Albert Einstein called it the eighth wonder of the world. Without it, it is almost impossible to build wealth and become financially free. However, with it, financial freedom is easy! You don’t necessarily need to pay an advisor to get it, as it is available to everyone. What is it?
Let me explain using a very simple, yet powerful story.
Two brothers: one ends up with over $2.7m and the other with less than $400k… why?
Author, Professor and director of the largest index fund provider (Vanguard), Burton Malkiel tells a story about two brothers in his book, The Elements of Investing:
The first brother, William, starts investing at age 20. He invests $4,000 per year until he is 40 and stops. The second brother, James, starts investing when he is 40. He also invests $4,000 per year until age 65. Both brothers retire at age 65. William’s investment balance is over $2.7 million whereas James’ investment balance is less than $400,000.
This story (illustrated in the graph below) clearly demonstrates the power of compounding returns and how important it is to not delay investing. Albert Einstein is quoted as saying, “compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Take 57 Donald Street for an example
I used to own an investment property at 57 Donald Street, Prahran, Victoria, but unfortunately had to sell it due to my marital separation. I want to use this real life example as another story to complement Malkiel’s one above. This property (Donald St) sold in December 1986 for $79,600 (this is the oldest sale recorded by RP Data). It’s most recent sale was in December 2014 for $1,050,000. This equates to a compounding annual growth rate of 9.6% p.a. over a 28 year period. If we average out the growth over that period and review it every 7 years (i.e. one quarter of the period), it is powerful to see the distribution of returns.
The first quartile represents 25% of the time period (being 7 years) yet the investor only enjoys 7% of the investment’s dollar value return. You will note that the dollar gain in the first quartile is $72k, compared to nearly $500k in the last quartile. That is, an investor gets nearly seven times the dollar value returns in the last quartile, compared to the first quartile. Long-term investors are rewarded by compounding returns, short-term investors are not.
Remember, this is a real-life example and there are plenty more examples of properties growing at 9.6% p.a. over the past 20 to 30 years. A few select properties will achieve the same growth rates over the next 20 to 30 years too – more about this soon.
So you realise that you should have started 20 years ago! What now?
Sometimes clients say to me; “Stuart, that’s a good story, but how many 20 year-olds start investing and do so religiously every year until they are 40? Anyway, I’m 40. I have lost the last 20 years. What can I do?” There are two responses to this statement/question.
Firstly, it is never too late to start. Life expectancy is increasing and people currently in their 40’s can expect to live to age 80 to 90 years. But with advances in anti-ageing and regenerative medicine, life expectancy is almost certainly on the rise. Therefore, if you are aiming to retire at or around age 60, you need to make sure you will have enough capital (assets) to last at least 30 years, otherwise you risk running out of money in retirement. So if you are aged 50 today, not only do you need to invest now to fund initial retirement in 10 years’ time, but also to ensure your assets continue to grow to fund retirement when you are in your 80’s and 90’s.
Secondly, you need to borrow money to catch up. The longer you have to build wealth, the less risk you need to take. Referring back to the example above that involved William (i.e. the brother that started investing at age 20), he starting investing 45 years before retirement so he didn’t need to take much risk at all (i.e. no need to borrow money – just invest a little bit, regularly). However, if you are 40 years of age now (or older) and have comparatively little investments assets today, you need to take more risk than William.
Specifically, you need to borrow to invest. By age 40, William’s investment balance was only $250k. Therefore, instead of James starting from zero at age 40, he should have borrowed $250k and invested it. Then he could have spent the next 25 years putting $4k p.a. into the loan. The loan would have been reduced by $100k to $150k but his investment balance would have been the same as William’s at $2.7m – so the difference between their two balances would have only been $150k (the amount of the loan), not over $2.3 million as stated in the original example.
There are only two ingredients needed to achieve these massive compound returns
The financial services industry loves to make things more complex than they need to be! It is a good business strategy. If you make things more complex, you can create dependency, i.e. people feel like they need an advisor to guide them through a complex maze of options. But this is nothing more than just good marketing. I’m happy to tell you that it’s absolutely not complex. In fact, being successful with investing is simple if you know how to do it and you are disciplined. There are really only two ingredients you need and they are time and quality assets.
The first ingredient is time, or maybe I should call it patience. Let me remind you of the Donald Street example above. If the same person that bought the property in 1986 still owned it, they would have a property worth over $1 million of equity today (because the income from the property would have repaid the loan by now). You need to understand that you really need to wait 10 years before you can expect to see any major changes in equity in your investment assets. That’s not to say you close your eyes and cross your fingers. Not at all. You need to review your investments to ensure they are performing well. Whilst you have to realise that good investments take time, it is important that your assets show all the right signs (now) and have the right fundamentals to give you the confidence that they will produce investment-grade returns. Conversely, if you believe some assets are not investment-grade, then you need to divest of these assets without delay. The opportunity cost is just too high.
The second ingredient is quality. The quality of your investments will determine your returns (i.e. the amount of money you make). Good quality investments will produce good quality returns and the reverse is true too – you will never receive good returns from poor quality assets. My advice is to never compromise on quality, because many people do. Have a single-minded dogmatic focus on quality. If an investment-grade property needs to fulfil 20 criteria to be defined as an investable asset for example, make sure you can tick all 20 boxes before you invest. Don’t invest in a property that ticks 19 out of 20 criteria. ‘Pretty close’ is not good enough when it comes to investing. Just a 1% p.a. difference in growth rate (i.e. 9.6% versus 8.6% p.a.) would make a $235k difference to the value of Donald Street today. My advice is to only invest in the best quality assets – there is no need to make compromises.
Remember, you only need to know ‘how’ to invest, not what to invest in. The ‘how’ is; focus on quality. When it comes to selecting and assessing the quality of an asset, you need to seek expert advice. You do not need to become the expert yourself. Bestselling author, Malcolm Gladwell tells us that it takes 10,000 hours of practice to become an expert in any field – do you have a spare 10,000 hours? Just knowing that quality should be your sole focus is sufficient to become a successful investor.
Are you smarter than Albert Einstein?
Compounding returns impressed Albert Einstein sufficiently for him to call it the eighth wonder of the world. I hope the above two examples have demonstrated to you the importance and value of compounding returns. You only need two ingredients to implement this strategy. You must have assets that produce strong compounding growth – they will do all the hard work for you. You cannot earn your way to retirement i.e. making money and saving it in a bank account. In addition, most dentists will need to make friends with the fact that they have to borrow money to invest, unless they are starting very early in life. And it’s never too late to start.
How many of your investments will grow in value at a rate of 9.6% p.a. over the next 28 years? If your answer is not “all”, you need to make some changes as soon as possible.