The secret to long-term wealth creation
We like an argument, David Stevenson, Tom Tragett and I. We relish a good debate about the investment outlook and we are often on opposite sides of the fence.
But there is one thing that we do agree on…
Without any if or buts, preconditions or qualifications, we agree about it. In fact there is not a single investment adviser who would not agree with it.
So it must be the most important investment advice of all time. An essential foundation upon which to build any investment strategy. It is nice and simple and applies to everybody.
Save as much as you can and for as long as possible.
That’s it! As easy as that!
You don’t need an economics degree to understand that message. You don’t need to have a view about markets or even take any interest in them. You just need to realize that if you want to spend your ‘golden years’ doing other things than worrying about money you need to start saving as early as you can and save as much as possible.
OK, I can hear some of you turning off already. ‘How can I save?’ you ask. ‘I can barely make ends meet as it is. I simply don’t have anything left over at the end of the month.’
Well sure it is hard for a lot or people. I know that housing is expensive and the cost of living rises relentlessly. But still when I look round I see most people wasting money. Why buy coffee and sandwiches when you could make your own? Who needs expensive trainers? Who, for that matter, needs an I-phone? I cope perfectly well without one.
What I am saying is that saving is largely an attitude of mind. If you want to save you can. I look at it this way. Most people live ‘within their means’. They do not spend more money than they have. Sensibly, they don’t want to get into debt. So if they are balancing their income with their spending it is just a short and simple step to spend a bit less and set something aside in the piggy bank.
But this is not a sermon. This is a maths class. Let’s do a few calculations and to make it easy I want you to find the Compound Interest Calculator at thecalculatorsite.com, which you can find here.
Let’s do an exercise. Start by making £ your base currency. Then as your ‘Base Amount’ put £1,000. For the ‘Annual Interest Rate’ put 5%. For the ‘Calculation Period’ put 10 years, and for the ‘Compound Interval’ select Yearly. Hit ‘Calculate’ and you will see a figure of £1,628.89.
Now that might surprise you. After all if you make 5% a year on £1,000 that is £50. Ten years worth of this comes to £500. So how come we have £1,628.89 after ten years and not £1,500?
The answer is that in the second year we start to earn interest not only on the £1000 starting sum but also on the £50 interest that was earned in the first year. In year three we start to earn interest on the interest that was earned in both years 1 and 2… and so on. So as you can see from the Calculation Results by year 10 we are receiving interest of £77.57, and by the end of the ten years we have earned total interest of £628.89.
This is known as ‘Compound Interest’. The world’s most successful investor Warren Buffett attributes his success first and foremost to compound interest. It an awesome financial force and harnessing the power of compound interest is the key to long term wealth creation.
Let’s go back to our calculation. Now instead of leaving our £1,000 earning 5% for ten years we are going to leave it for twenty years. Just follow the same steps as before, only this time set the Calculation Period as 20 years. After 20 years our £1,000 has turned into £2,653.30.
Does that seem odd? After all in the first 10 years we only made £628.89. In the second ten years we have made another £1,024.41. Once again this extra return is thanks to compound interest. After 30 years our £1,000 becomes £4,321.94, after 40 years, £7,039.99, and after 50 years £11,467.40.
That’s right. After 40 years our starting stake of £1,000 has multiplied more than seven-fold and after fifty years more than eleven-fold. Half a century might seem a long time, but if you are in your twenties I’ll bet you envisage being alive in your seventies. So your investment time horizon should be measured in decades.
Now let’s do the calculations again, but this time starting with £2,000. Now we get £3,257.79 after ten years, £5,306.60 after 20 years, £8,643.88 after 30 years, £14,079.98 after 40 years and £22,934.80 after 50 years.
These totals, you will have spotted, are exactly double those of when we started with £1000. And yet the absolute gain is much larger. After 30 years our £1000 has become £4,321.94, giving a gain of £3,321.94, but the gain on £2000 over the same period is £6,643.88.
You can play around with these calculations…
For example, try this: For the Base Amount enter ‘0’. For the Annual Interest Rate again hit 5%. For the Calculation Period choose 20 years. Where it says ‘Regular Monthly?’ put £100 and again choose ‘Yearly’ for the Compound Interval.
In this calculation we are saving £100 per month for 20 years. That is a total of £24,000. After twenty years this has become worth £40,745.78, a gain of £16,745.78. Again let’s extend it to 30 years. Now the £36,000 that we have set aside has become worth £81,869.78, a gain of £45,869.78.
If you are proficient with Word Excel you can use this formula: Total = A1*A2^A3, where in grid reference A1 you put the starting sum, in A2 you put the Rate of Interest and in A3 you put the number of years.
But however you cut it the message is the same:
The more you save and the longer you save it for, the richer you will ultimately become.
That is today’s lesson. But before I go I want you to do one more thing…
Go back to the first calculation, £1,000 invested at 5% for 10 years. Remember we calculated an end figure of £1,628.89. Now let’s change the annual rate of return to 10%. We have doubled the rate of return. Have we also doubled the eventual gain? Remember that with 5% we made £628.89. But with 10% we make £1,593.74, much more than double.
If we extend the period to 20 years our £1,000, which earned us £1,653.30 at a rate of 5%, earns us £5,727.50 at a rate of 10%, about three and a half times as much.
Obviously the rate of return is important, which is why the experts expend such a lot of energy discussing market prospects.
For a good summary of long term returns the bible is the Credit Suisse Global Investment Returns Yearbook. You can find the 2018 edition here.
The lesson of history is that the best long term returns come from investing in equities (shares) and if you can do it yourself and save paying an investment manager 1%-2% per year (which by, for example, reducing your annual return from 7% to 5.5% has a considerable long term impact on your wealth) then so much the better.
But while the rate of return is to an extent beyond your control the amount that you save and the time that you save it for is very much within your control.
So sacrifice the daily coffee, vow never to buy another sandwich that you could have made yourself and start planning that retirement villa in the Bahamas.