I was binge watching a fictional Netflix series last week about a group of 4 guys who had made an app that had become a huge hit, Angry Birds style.
Each of the 4 guys had particular skills, and there was a scene where one of the guys was feeling pretty lost. He bemoaned to his friend how such and such was great at art, another coding, and the 3rd guy, the one he was speaking to, was great at game design. But he asked, what was he in the group for?
His friend considered this for a moment and said, “you know what you are in the team for? You’re the power-ups. When we were just about to run out of money, you went out and found more. When Johnny went off the rails, you brought him back. You hired some key people without whom, none of this success would have happened. And you made us all rich when you found a buyer willing buy our business. So, yeah, you’re the power-ups”.
It was a great scene and it really stuck with me. It also made me think about what the power-ups are in the investment world. What are those things that really accelerate your investment plans? Well, I believe there are 3, and that’s what we’ll be exploring in today’s episode.
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Wikipedia describes power-ups as “objects that instantly benefit or add extra abilities to the game character as a game mechanic.”
If you’re old enough to remember Pac-Man, the power-up of eating the power dots in the corners let you chase the ghosts, or in Sonic the Hedgehog, the most common power-up made you go much faster. From Super Mario Bros to modern day Clash of Clans, power-ups are an integral part of most video games.
Whilst all of these games can be played without the power-ups, the core objective of the game is either impossible or at least extremely difficult to achieve without using them.
And so when thinking about the achievement of your Financial Autonomy goal, whether that be a 6 month mini retirement at age 40, a career change next year, or a move to a regional town, what are the investment equivalents of a power-up, that can bring your goals within reach.
I have identified 3 investment power-ups. They are:
- Regular savings and dollar cost averaging
- Dividend reinvestment and compounding
Let’s take a look at each in some detail.
Regular savings and dollar cost averaging
If you want to build up wealth to gain the choices in life that you deserve, then you need to save. And there is no better way to save than to commit to a regular savings plan. By this, I mean you have an automated process whereby a certain amount of money is transferred out of your normal living bank account and into investments.
There are two reasons why this strategy brings success. For one, it bakes in discipline. The investment just happens. No chance for you to spend the money on some other non-essential item, or use the cash to book a flight to Hawaii. Part of the discipline benefit is also that it ensures you live to your budget – the money just comes straight out of your account, so you can only live off what remains. Savings discipline is far from an easy thing, so don’t under-estimate this benefit.
The second reason an automated regular savings plan works is because of dollar cost averaging. Now I realise this is a bit of jargon, which is something I usually try to avoid, but in this case it’s not a tough concept to get your head around.
Dollar cost averaging deals with the fact that there is never a perfect time to invest. It reminds me of something a keen fishing friend of mine once told me – “the best time to go fishing is whenever you can”.
So rather than picking one moment in time and hoping that it proves to be a great entry point for your investment, you invest regularly, typically monthly. The price that you pay for your investment will vary month to month. Some months you pay a little more, some a little less. But over time what you get is the average price. Sure you don’t get the lowest price, but you also don’t get the highest either.
A great example of how effective this process can be was seen during the 2008 period where share markets declined considerably. Many people who invest discretionarily, put things on hold during that period and sat on their cash. But for those with automated regular savings plans, they bought every month, and when markets recovered from 2009 onwards, the prices they paid for their investments during that period looked really attractive. There was no way to know during 2008 when the market would reach the bottom. So holding off and trying to pick that point is a mugs game. But through the discipline of investing regularly, you continue to buy during the dips, and you get the dollar cost average benefits of averaging out your purchase price.
In fact assuming you are an employee, you are already engaged in an automated savings plan that utilises dollar cost averaging – it’s your superannuation contributions.
The second investment power-up is Gearing, and this is probably the most impactful.
Gearing means borrowing for investment purposes, and like gears in an engine, the purpose is to magnify outcomes. As a simple illustration, if you have $10,000 invested and it grew by 8%, at the end of the year you would have $10,800. But had you matched that $10,000 with another $10,000 or borrowed money, your total investment would have grown to $21,600. Once you paid back the $10,000 that you borrowed, you’d be left with $11,600, so double the gain, or growth of $1,600, compared to the original $800.
Now of course no-one will lend you the money for free, so you will need to pay some interest on the money that you borrowed, and that will reduce your gain. Indeed if the cost of borrowing were high enough you would reach a point where it would wipe out all of the gain. But the point is that for the same investment return, your gain is greater as a consequence of having geared.
Now of course when thinking about gearing it is always important to remember that gearing magnifies both positive and negative outcomes. So in the earlier example, had the original investment lost 8%, then under the geared scenario the outcome would have been even worse.
So gearing isn’t a free hit. It needs to be considered thoroughly. In particular your investment time frame is important. You need to be able to wait out an investment market downturn. In my work with clients I wouldn’t consider a gearing strategy unless the investor had a time frame of at least 5 years.
Property investment is perhaps the best known form of geared investment. There aren’t many people who pay cash for a property. Back in episode 25 I highlighted the significant impact that gearing had on my first property purchase, so if you haven’t already consumed that one, check it out Episode 25 – My 68% return. The power of gearing – how smart borrowing can accelerate your journey to financial autonomy.
Dividend reinvestment and compounding
I’ve written and spoken a lot about the power of compounding, most recently in the Settlers of Catan / Early Retirement episode, number 43. Sometimes described as the 8th wonder of the world, the idea of earning interest on your interest is compelling, and certainly qualifies as an investment power-up.
The best use of compounding is reinvesting dividends on share and ETF investments. I’ve had several clients over the years who bought Commonwealth Bank shares back when they floated all those years ago. They bought a few thousand dollars’ worth, and ticked the box to have the dividends reinvested. That means that each 6 months when a dividend is paid, instead of the investor receiving the cash, the money is used to buy more shares.
Roll forward 20+ years, they’re retired and are thinking about a new car or a big European holiday. Those CBA shares that they haven’t given much thought to are now worth $80,000, and they’ve got some great options. Sure, the share price has gone up, but that alone would have only gotten them to about $25,000. The rest of the growth is the power of compounding. And let’s face it, if they had have taken the cash with each dividend payment, it would have just got absorbed into the normal spending. A new pair of shoes, or the electricity bill. There’d be nothing to show for it now.
Again, your super fund will be doing a form of this. All the earnings go back into the fund to fuel further growth. It explains why, early on in your working life your balance doesn’t seem to grow a lot, but 20 years into your career you tend to see more rapid gains – this is your past earnings generating new earnings.
So there you have it, my 3 investment power-ups – Regular Savings and Dollar Cost Averaging, Gearing, and Dividend Reinvestment and Compounding.
Hopefully you can use some or all of these to power-up your journey to Financial Autonomy.
Until next week, bye for now.
Resources & Links
- Podcast Version
- Game Mechanics
- My 68% return. The power of gearing – how smart borrowing can accelerate your journey to financial autonomy
- How Settlers of Catan can help you achieve Early Retirement