Successful investing is relatively easy but many people and some professionals overcomplicate it.
I have discovered that most people do not understand or fully appreciate two very important, yet simple principles.
Firstly, there are typically two steps to a retirement strategy – most people think there’s only one and this is where they become misguided and make mistakes.
Secondly, most of your return comes after 10 years.
I find that once people appreciate the importance of these two points, they seem to have a far better understanding of what a low-risk, high-return investment strategy looks like.
They become successful investors.
After 10 years you’ll double your return
Consider the situation where you invest in an asset worth $500,000 today and the value of that asset grows at 8% each year over the next 15 years.
Of course, assets rarely grow uniformly each year but let’s assume the average growth is 8%.
In 15 years’ time that asset will be worth just under $1.6 million.
Therefore, this investment has generated $1.1 million of wealth (being $1.6m less $500k) over the 15 year period.
The graph below sets out when this growth occurred.
It is very interesting to note that in the first 5 years only 21% of the growth occurred whereas in the last 5 years 47% of the growth occurred – i.e. in only one third of the time period (5 years) the investor enjoyed 47% of the return.
The return in the last 5 years is more than double (in dollar terms) than what occurred in the first 5 years.
This demonstrates the importance of investing in assets (property or shares) that generate perpetual capital growth because it is the combination of compounding growth plus time that will ultimately deliver your return.
Please read that sentence again as it’s very, very important.
The difference between perpetual growth and…
Some clients approach us to discuss different investment strategies such as property development, renovations, trying to locate the next growth suburb and similar strategies like these.
They are rarely appropriate for our clients because one of the characteristics of these strategies is that they do not provide sustainable and perpetual capital growth.
More often than not they will provide a once-off spurt of growth/value or a short period of strong growth – but not long term perpetual growth that an investment-grade asset should provide (i.e. 7-10% p.a.).
Therefore, to achieve perpetual growth you need to be activity investing (i.e. buying, selling, renovating, developing, etc.) and as a result paying a lot of taxes and stamp duty along the way – the strategy is hard work and more akin to a business than passive investment.
It is far easier (and lower risk) to buy a quality asset and let time and compounding growth do all the heavy lifting.
But will growth really be perpetual Stuart?
A common question I’m asked is: surely property can’t continue to grow at a rate of 8% p.a. over the long forever?
The short answer is “no, correct”.
The longer answer is twofold.
Firstly, let’s be clear that I’m only talking about investment-grade property.
That is, blue-chip, high-quality property – maybe only less than 3-5% of properties that exist.
Secondly, mathematically, even investment-grade property cannot grow at 8% p.a. forever (i.e. over next 1,000 years).
There will be a time when it will level out – it has to because affordability will become an issue.
However, I’m pretty certain that we don’t need to worry about this happening in our lifetime and I’m equally sure that my kids don’t have to worry about it in their lifetime too.
Australian capital cities have a long way to go to reach the density (saturation) that you see in, for example New York, Paris, London and similar cities.
In summary, if you focus on buying the highest quality asset you possibly can then there’s a very high probability the asset will increase in value at a rate of 7-10% over the next 30 or so years.
Time is a key ingredient but it’s never too late
You can always make money back but you’ll never be able to make time back.
The more time you have, the less risk you need to take to reach your goal.
A 30 year old wanting to retire at age 55 has to take very few risks to fund retirement – they just need to invest slowly and steadily in quality assets.
Conversely, a 50 year old wanting to retire at 60 will need to take a comparatively higher amount of risk (invest more aggressively).
That said, it is never too late to start.
The key message here is; if you are risk adverse when it comes to investing, the worst thing you can do is procrastinate.
Procrastination (i.e. delaying investing) results in you eventually needing to take higher risk because your investment time horizon is shorter.
Ironically, sometimes the cause of procrastination is fear (risk aversion).
Two shots – investing is like playing golf
My second key point in this newsletter is to address the assumption that investing in residential property alone is a good strategy to fund retirement.
Most people need their investments to generate a passive income in retirement (of let’s say $80,000-100,000 in today’s money).
When they consider how much money (equity) they may need to generate in property they start to think that they need to buy lots of property.
Alternately, they start to invest in property for yield (income) with less focus on capital growth.
The correct answer is that there are two steps to developing an asset base that produces a strong passive income.
The first step is to invest in assets that give nearly all their return in capital growth (because a higher income return while you are working means paying more tax which means you have less to reinvest).
The second step, once you have generated a strong asset base (via capital growth) is to tilt your asset allocation towards income style investments – more about this later.
Let me explain using a golf analogy.
In golf, you typically use a driver to tee off because drivers allow you to hit the ball a long distance.
Then, when you are on the green you use a putter because they are more accurate than drivers.
You could tee off with a putter but it’s going to take a long time to finish the hole and its hard work.
The same is true with investing.
Investing in income style assets from the start with the aim of building (growing) your asset base is an inefficient strategy.
Instead, invest in capital growth assets (driver) and when your asset base (net worth) is large enough then tilt your assets towards income (putter).
So what do I mean “tilt your assets towards income”?
I mean start investing in assets where most of the investment return is income rather than capital growth.
This may include investing in commercial property (maybe syndicate), accumulating cash savings in an offset account linked to your property loans for liquidity, investing in fixed interest investments or some shares and so forth.
There are a few options and the most appropriate will depend on your time line and circumstances.
The simple point is; a retirement strategy usually involves two phases – accumulation and then income – which many people don’t appreciate.