Let’s talk about wealth creation. Specifically what can we do to accelerate it, hit the fast forward button. Of course there’s all the standard and perfectly prudent advice that we’ve covered many times before, spend less and save more, chase a new higher paying job, and ensure any surplus cash is invested and working rather than lolling around in a bank account, failing to keep up with inflation.
For the purpose of this weeks episode I’m going to assume that you’ve done all that.
I’m also going to assume that you have a time horizon of at least 10 years. If your time frame is less than this, then it’s quite likely the strategies being talked about today involve more risk than would be sensible for you.
As always, keep in mind that the information shared here is general in nature and does not take into account your specific circumstances. You should always obtain advice that is tailored to you before investing money or making changes to existing investments. Go to the Advice page on the Financial Autonomy web site to see how we can assist in that regard.
Okay, with that preamble out the way, let’s dive into this week’s post, 3 tips to rapidly accelerate your wealth creation.
If we are to accelerate your wealth creation, we need your earnings to be higher and then rely on the power of compounding to do its work. In my Financial Autonomy book on page 94, I have a table showing the doubling maths. If you invest your money such that it earns 5% then your savings will double in value in a little over 14 years. However if you can push this earnings rate up to 9%, your money will take only eight years to double.
So let’s think about this. You have $100,000 to invest. In the 5% rate of return case, 14 years after investing your $100,000 it will have grown to $200,000. But had you earned 9% instead then after 8 years you are at $200,000 and at the 16 year point, so only a couple of years longer than we considered at the lower rate of return, you have doubled again so that your $100,000 is now $400,000. Only two years further down the road but you now have twice as much money as a result of achieving that higher rate of return.
And the longer the time frame that you run this out, the greater the difference will be. Eight years further down the road and that $400,000 has doubled to $800,000 whereas the lower earning money still hasn’t had enough time to achieve its second doubling. GainingCHOICE readers might recall that I’ve shared articles around a key to Warren Buffett’s success being that he started investing very young, about 14 years of age, and he’s had the good fortune to live a very long life. This gives a lot of time for doubling to happen. 100 becomes 200, 200 becomes 400, 400 becomes 800, then 800 becomes 1.6 million. The power of compounding is huge.
You can see that lifting your rate of earnings is the key to accelerating your wealth creation. But of course we all know there’s no such thing as a free lunch. An investment that earns 9% is going to be riskier than an alternative investment paying 5%. Sometimes the marketers might try to spin it to convince you otherwise, but that’s the equivalent of attempting to defy gravity.
To accelerate your wealth creation then, you need to be prepared to take on more risk. Now we’re not talking about crazy risks. I’m certainly not suggesting you mortgage the house and put it into crypto or cannabis stocks. But the level of risk in your portfolio can be raised prudently if you have an appropriate investment timeframe, and an appropriate overall financial structure with things like an emergency account and income protection insurance.
Let’s now consider three ways you could turn up the risk dial to accelerate your wealth creation.
1. Discard Defensive Assets From Your Investment Holdings
Defensive assets are cash and bonds. Whilst bonds have had a pretty terrible past 12 months, generally speaking these defensive assets provide stability in your portfolio. But this stability comes at a cost. That cost is lower overall returns.
Some numbers from researcher Lonsec found that a typical balanced fund, which is a fund that has 40% of its allocation in defensive assets, has earned an average return of 6.9% since the beginning of this century. In comparison a portfolio with no defensive assets has earned on average 8.1% per year.
Now as already mentioned, there’s no such thing as a free lunch. The balanced investor had to tolerate a drop in their portfolio value of just under 20% in the worst 12 month period of this time frame. The 100% growth investor however saw their portfolio drop by 35% in this worst window, almost certainly during the GFC of 2008. There was also a significant difference in the frequency of negative returns. The balanced investor experienced a negative return roughly one in every five years, whereas the total growth investor saw a negative result every 3.8 years.
All these numbers tell you that higher returns are available for those prepared to discard defensive assets, but you need to do so with the full knowledge that the price to be paid for these higher returns is greater variability of your returns from one year to the next. Put another way, the range of outcomes is wider for the total growth portfolio than it is for the balanced portfolio.
Besides psychologically conditioning yourself to be able to handle such volatility the other key is to have a long time frame. In this respect, this idea of discarding defensive assets is perhaps most appropriate for your superannuation savings, assuming retirement is still a considerable way off. Given the preservation rules prevent you accessing your superannuation savings until you are at least 60 years of age, this pool of savings is especially well suited to investing for the long term and riding out short term volatility.
The next way to ratchet up your risk is to add leverage via borrowing. Many Australians have built wealth through property investment. Interestingly, when you look at the investment in isolation it’s often not a stunning success. Properties constantly need maintenance and the rent barely covers the holding costs.
But the secret to properties success is the ease with which it can be leveraged. For just a small deposit you can have exposure to an asset worth hundreds of thousands of dollars if not millions. In fact for those with equity in their home, they might be able to pay no deposit at all to gain this exposure.
If you put a $100,000 deposit down on $1,000,000 property and sometime later that property increases in value by 10%, then very simplistically your initial investment just doubled in value. You borrowed $900,000 at the outset, when you sold the property for $1.1 million you paid that loan back, leaving $200,000 in your pocket. Again this is greatly simplified but it perfectly illustrates the significant impact that leverage can have on your investments.
Borrowing to invest isn’t the exclusive domain of property. Many of our clients leverage into share investments. Whilst you generally can’t be as aggressive when gearing into shares as you can with property, borrowing to invest in shares has a number of advantages. Firstly there are no maintenance costs or bills to be paid on a share portfolio. The dividend income, though lumpy and less frequent then is the case for an investment property, is nonetheless fairly reliable. There’s no potential for zero income as is the case with the property where it might be vacant for several months. Gearing into a share portfolio also offers considerable diversification benefits. You would typically gear into a fund holding hundreds if not thousands of different underlying companies across all different industry sectors, which provides considerable resiliency.
Whether property or shares is the appropriate investment asset for you, adding gearing is definitely a way to increase risk in your portfolio and thereby accelerate wealth creation for a long term investor.
3. Bias to US Shares and Small Caps
My third suggestion as to how you might accelerate your wealth creation is based on historical return data. Now of course none of us know what the future will bring, and you will have seen the normal caveats about past returns not being indicative of future returns. So keep that in mind while I talk you through this third idea.
A final way to get more aggressive with your portfolio would be to bias it towards US shares and Small Caps. By necessity, this means having less exposure to large cap Australian shares. The small caps bias could be both Australian and global.
Over the past 30 years, US shares have delivered returns almost 2% per year better than Australian shares on average. Now perhaps this won’t be repeated in the coming decades, but it’s tough to see what change has occured that would alter this playing field. Our local market is dominated by three big mining companies, four very large banks (five if you include Macquarie), and CSL, Wesfarmers, and Telstra. Those mining companies have a very interesting future as we transition to an electric and sustainable world. And CSL has a great track record of growing and expanding internationally. But the rest of these businesses are fairly slow and steady wins the race types. Good reliable dividend producers, but they’re not going to double sales anytime soon.
The biggest stock on the US market is Apple, the second largest is Microsoft. Whilst the US certainly has its share of banks and mundane type businesses, it seems to be a market where growth oriented companies are more highly valued and sought after. Microsoft have just released their latest quarterly result, with revenue up 11% despite declining PC sales which impacted their revenue from their Windows operating system. In market capitalization terms Microsoft is bigger than almost the entire Australian stock market. The fact that a behemoth like this is still able to grow revenue in the double digits is extraordinary and provides some insight into why for investors chasing growth, a bias to the US stock market would seem wise.
A bias to small caps similarly seeks to address the low growth tendency of Australian large cap stocks. The banks are operating in a well defined marketspace, and whilst they might be able to pinch a little bit of business from a competitor, there’s just no room for them to double or triple rapidly. Smaller companies however typically have far more potential to gain market share and therefore achieve growth. Of course there is huge execution risk in this and so small cap investors endure far more of a rollercoaster investment experience, and diversification is extremely important. On average however small cap stocks have produced greater returns for investors. In the global space, small cap stocks have produced on average a 2.3% greater return then the large cap biased global equities index.
So there you have my three tips to accelerate your wealth creation:
- discard defensive assets
- bias your portfolio towards US stocks and small caps
Appreciate that each of these ideas increase your risk, so ensure you obtain professional advice, and consider thoroughly their appropriateness to your circumstances.Back to All News