By Doug Wroe
“The Most Powerful Force In The Universe Is Compound Interest” Albert Einstein
Compounding simply means multiplying; instead of adding.
When building wealth by increasing the number of assets that you control there are two basic strategies; Addition and Multiplication. Using Addition will obviously add to your wealth but it is Multiplication that will truly accelerate that growth. Let me explain further what Albert meant when he uttered the quote above.
Doing It The Addition Way
Saving the money required to purchase an asset would result in you adding to your portfolio the equivalent value of the asset. Repeating this process and saving enough to purchase another similar asset is what I call doing it the hard way!
Let’s face it, very few people have the disposable income to save that much anyway.
Borrowing against an initial asset when looking to secure subsequent ones will fast track wealth creation. Not doing so will probably restrict the average person to securing just one or two assets, of any significance.
If you have no significant assets (such as property) when starting out, saving may be your only option to get started. Aside from those who use someone else’s equity (such as a parent), most of us are forced to save for that first deposit.
While it is common to start out this way, you probably don’t want to maintain such an approach as doing so will limit the size of your asset base to considerably less than it potentially could have been.
Purchasing an asset in an entity that does not allow you to later borrow against that increased value of the first asset means you may be limiting your options to an addition strategy. I believe this to be the case with superannuation, however, please check with your accountant as my understanding of purchasing in superannuation is limited.
Doing It The Multiplication Way
This is possible once your initial asset(s) has grown in value enough to offer the additional equity necessary to purchase subsequent asset(s). This method (of leveraging as it is called) is what I call doing it the easy way!
Once your initial asset has seen sufficient growth in value, you can draw the necessary deposit from there to secure another asset.
So now you have two assets, which in turn continue to grow in value and provide deposits for two more. Then you have four! Those four assets grow in value and provide deposits for four more. Then you have eight! You can see the pattern. It is a bit like a snowball. It takes some time and effort to get it rolling down the hill but it will pick up speed and increase in size to a point you couldn’t stop it even if you wanted to.
Let’s Compare The Results Assuming Five Purchasing Cycles
Addition:
1 + 1 + 1 + 1 + 1 = 5 Assets.
This relies on you being able to save enough deposit for each purchase.
Multiplication:
1 X 2 = 2
2 X 2 =4
4 X 2 =8
8 X 2 = 16 Assets.
This doesn’t rely on you being able to save enough deposit for the next purchase (perhaps just the first).
The difference is 11 Assets. That could potentially be worth millions of dollars.
You may have also noticed that the greatest increase is in the later doubling cycles. This highlights the need to get your name on the first asset and start the purchasing cycles as soon as possible. We all have a finite time available to us to invest, some shorter than others. If we delay starting to invest so that we only have 4 purchasing cycles instead of 5 the difference in the end result is dramatic.
Every day that you delay shortens your available investment window. It doesn’t take it off the first cycle, it takes it off the last one!!
As we all have this finite investment time window, increasing the number of cycles within that time window can be very beneficial also. If you were to invest in an asset that provided a low Return ON Equity then it would take you longer to build a deposit to buy your next asset. The length of the cycles would be longer, therefore you would have fewer cycles in your available time window.
For example let’s assume you have a time window of 15 years available to you. If your chosen asset grew enough to provide a deposit for another in five years then you would have three purchasing cycles available to you. If you chose an asset that performed the same growth in three years then you would have five purchasing cycles available to you – with the corresponding dramatic effect on the end result.
In the example above, three purchasing cycles equates to four assets being held however five purchasing cycles equates to 16 assets being held!
As you can see, both the time window available to you and the length of the purchasing cycle are crucial and will make a dramatic difference to where you and your family are when you move into your retirement.
Please note that we are not discussing asset doubling cycles, we are discussing how long it takes an asset to increase in value enough to be able to provide a deposit for another.
There Are Ways That You Can Shorten The Length Of These Cycles
Purchase an asset that grows quickly and predictably
Obviously if you are able to choose an asset that grew quickly and predictably you would have enough for your next deposit sooner. The problem is that we cannot see into the future and so cannot predict with certainty which assets will perform like this.
mrd puts a lot of time, money and effort into filtering potential properties to isolate those that we believe will grow quicker and more reliably. We look at history, examine the forces that have created growth and then project that forward in our search for areas and properties that we expect to do well considering future demographic needs.
Choose an asset class that only needs a small deposit to control
As mentioned in last week’s article “Leverage – The First Driver Of Wealth” there are assets that allow you to use a 100 to 1 gearing ratio. With assets such as these you only need a small deposit and it would not take much growth before you had enough equity for another. The issue here would be volatility and Return OF Equity as a small move against you would wipe out your savings and perhaps more.
The ideal asset for this purpose would be one that needed a small deposit but was also relatively stable. It is no secret that I am referring to residential property.
Use finance methods that make the best use of gearing
By using a median priced residential property asset it is possible to lend up to 95% of its value requiring just a 5% deposit, plus purchase and lending costs. With such an asset it may be possible to secure funding with a very small deposit. This strategy enables you to use as little of your own equity as possible and thus assist you to add your next asset purchase (and grow your portfolio value) that much sooner!
Higher gearing allows you to compound faster
By now I expect you will have a greater affinity with Albert Einstein when he made the remark I opened with… ” The power of compounding to greatly enhance your end result is clearly evident.”
By using a combination of leverage and compounding you can achieve great results.
Next week we will look at the effect of inflation and how this third driver of wealth will add to these first two to create a tsunami of wealth and open up many more choices for you in the future. Be sure to look out for the next newsletter.
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Happy Investing,
Nick Lockhart
mrd Customer Care Program… because investing is personal
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