Investing is a key component of achieving financial freedom. An investor that constructs a portfolio using broad based stock index funds can typically expect an average return of 6% – 9% per annum. When compounded over the long run this produces amazing results. However, the first few years are pretty painful as compounding only accounts for a small proportion of portfolio growth. Let’s take a look at a portfolio that has $20,000 added to it at the start of each year and grows at a rate of 7% p.a.
During the first 3 years we observe the portfolio increasing by around $21,000 each year, however, this raw growth is mostly the result of the yearly $20,000 contributions made by the household. Only during the 5th year does the growth from compounding approach one third of the value of the contributions. Unfortunately, this means for your investing journey you’ll be doing most of the heavy lifting at the start. Don’t worry, I’ve been there too, I appreciate your pain.
Implications
While this all sounds like doom and gloom, the objective of this post is not to deter you from investing but rather to set expectations for the start of an investment journey and shift your focus towards activities that can help you build wealth quickly.
Focus heavily on the size of contributions at the start
Because of the fact that the majority of portfolio growth comes from contributions at the beginning generating high returns are of less importance than the size of your contributions.
To illustrate this numerically, let’s compare the above portfolio to one that grows at a rate of 14% p.a. instead of 7%.
After 5 years we see that the portfolio growing at 14% reaches a value of $136,931 compared with $116,850 for the 7% growth rate portfolio. While $20,000 extra may seem like a significant amount, this needs to be understood in the context of how much more difficult, and risky, it would be to achieve 14% growth compared with 7%. Even the best fund managers in the world will struggle to consistently deliver 14% p.a. consistently over a period of 5 years.
In fact, after 5 years if a household invested $23,000 p.a. compounded at 7% this would result in a similar portfolio value ($134,377) to the portfolio growing at 14%. Investing $3,000 extra per year is only $57.70 per week.
The key lesson here is don’t spend too much time getting your asset allocation 100% perfect or looking for strategies to produce high returns. Instead, focus your effort on increasing your savings rate through increasing your income while optimizing your spending.
Keep an eye on fixed investment costs
This is especially true for fixed dollar value such as wrap platform minimum fees or trading costs. For example, if you are paying a fixed admin fee of $30 per month this will affect you much more at $5,000 than it will it $50,000. This also applies to purchasing multiple ETF’s to construct your portfolio – in some cases, due to transaction costs, it may be better to simply purchase a single ETF at each investment period. For example, if you wanted to own VGS and VAS ETF’s but only had $1000 per month to invest you could purchase VGS one month and VAS the following month instead of purchasing both each month. This will cut yearly transaction from 24 to 12.
Volatility is easier to recover from
Losing half your portfolio value when it is at $20,000 is much easier to recover from than losing half your portfolio value at $200,000. Using the above example topping up a $10,000 cash balance will only take 6 months whereas topping up $100,000 will take 5 years. This means there is scope to take more risk with your portfolio and there is no need to sell overweight assets to perform rebalancing; this can be done by simply purchasing underweight assets.
Having said that, it is important to view this in the context of your overall life situation as well as your end goal of building a portfolio that provides a source of passive income to achieve financial freedom. As an example, you wouldn’t want to blindly increase risk if your portfolio is small but you need to retire in a short period of time. Also, if you repeatedly take risks that do not play out in your favor, you could end up deviating significantly from your initial projections of achieving financial independence.
Concluding thoughts
The start of any investing journey is a slow grind where portfolio growth will mostly come from your contributions. So, during the first few years, you should devote maximum effort to increasing your savings rate through increasing your income. For most people, this means working on your career/business while keeping an eye on your cost of living. This will help you quickly build your portfolio to a size where it starts to do much of the heavy lifting. The faster you do this the more time you will have to take advantage of compounding and reap the rewards of your hard work.
Engineer your freedom