The no brainer solution to wealth accumulation, keep it stupid simple….
If you’re like most people you are probably surprised that you have a lack of savings or assets to show compared to the amount of income that has come in and out of your pocket. You may have even managed to spend a bit more than you earned which might be reflected in a pretty unattractive credit card statement…….So what’s the solution?
The simplest and most effective method I have come across (one that I advise clients in this situation to use) in order to ensure people have some wealth to show for all of their toil is to follow the 50/30/20 rule. It’s stuuuupid simple:
Here’s the gist. Break your income into three buckets:
Bucket 1 - 50% – Basic Living Expenses (bills, food, necessities)
Bucket 2 - 30% – Wants (travel, going out, gadgets)
Bucket 3 - 20% – Savings/Investment/Debt reduction
By committing (it sometimes takes a couple of false starts!) to the 50/30/20 rule you will instantly begin to accumulate savings or eliminate debt which has a significant impact on both your bank balance and your mental attitude to money. The more you accumulate the more you begin to think in terms of what things really cost and if money may be better off invested than spent occasionally.
Let’s take a look at the effects of a long term example of this kind of behaviour. If an individual earning the median Australian’s taxable income of approximately $60,000 per annum broke up their income using the 50/30/20 rule they would have $24,000 to use for basic living expenses, $14,400 to fulfil their wants and $9,600 to save and invest.
Bucket 1 - $2,000 per month
Bucket 2 - $1,200 per month
Bucket 3 - $800 per month
If this individual started the strategy 10 years ago and invested the 20% savings amount using a balanced investment portfolio (one invested in both safe and risky investments) which provided a 7% return (actual average for the last 10 years), they would have a touch over $128,000 sitting in their investment portfolio…….not bad eh? That amount could have been even higher if more investment risk was taken (The ASX 300 retuned 9% per annum for the same period) or the wants bucket was reduced and sacrificed for the savings bucket!
Let’s examine a couple of the forces at work that combine to make this strategy so effective over time.
Compound interest and “The Rule of 72”
Compound interest is simply earning interest on the interest you already earned.
The sooner you start a savings and investment strategy the better! A neat way to calculate the effect of compounding and in particular, how long you can expect it to take for your investment to double in value, is by applying “The Rule of 72”. By dividing 72 by the historical average annual rate of return on your investment (let’s say our 7% return discussed earlier), investors can get a rough estimate of how many years it will take for their initial investment to duplicate itself. i.e. If we started with $50,000 (no additional investments) it would take 72/7 = 10.28 years to be worth $100,000. My favourite illustration of the power of compounding comes from a brilliant little Chinese tale, definitely true…..the numbers are, the story may not be….
“The Emperor of China was so excited about the game of chess that he offered the inventor one wish. The inventor wished for one grain of rice on the first square of the chess board, two grains on the second square, four on the third and so on through the 64th square. The unwitting emperor immediately agreed to the seemingly modest request. But two to the 64th power is 18 million trillion grains of rice—more than enough to cover the entire surface of the earth. The clever inventor did not gain all the rice in China; unfortunately he lost his head instead.”
Dollar cost averaging
Dollar cost averaging is simply the act of continually investing regular amounts at regular times regardless of the market value of an investment.
This is the exact opposite of trying to pick the right investment time which so many people consistently (read most people in history) fail miserably at. Over time, this will average out the cost of investment as you purchase more investment units when the market is low and less when the market is high, effectively managing your risk exposure vs saving up and making a once off investment. The effect can be seen in the below table, if you invested a $1,000 lump sum in January you would have an average cost of $8 per share however by drip feeding your funds over time your average cost becomes $7 per share. Result = a higher capital gain!
A practical solution
So how can you actually implement the strategy? Bucket 1 and 2 are simple enough, you just need two bank accounts and an automatic transfer set up each month. Bucket 3 is a little bit more tricky and comes with a few caveats and risks that you must understand before diving in head first.
The risk vs return trade-off
I always use this classic graph to help explain this concept. Essentially the more exposure you give yourself to growth assets (property and shares) the more risk you are taking and the more return you should expect to receive accordingly.
Accessing investment markets cost effectively
ETFs (Electronic Traded Funds), specifically index funds are one of the cheapest and easiest ways to access specific investment markets. An index is a group of securities designed to represent a broad market or a portion of the broad market. An example of a broad market may be the ASX 300. Be sure to do your research though as some of the companies that create the index funds don’t actually hold the underlying companies that they represent (they use tricky things called derivatives) and hence in a market downturn you could be left wondering why your investment is so different to it’s index.
Vanguard has a very long and trusted record in this space. You can purchase index ETFs using a stock broking account (Commsec, Etrade or CMC markets are popular) just be sure to note the brokerage on each transaction as this can significantly impact the effectiveness of the strategy. The cost to invest in the Vanguard Australian Shares Index ETF each year is 0.15% per annum (this is $15 on $10,000!) and is paid from the investment itself, not your pocket.
More info on Vanguard ETFs: http://goo.gl/ttTqtx
Managing your emotions during times of investment uncertainty
Investment uncertainty is and always will exist. People will always have an opinion and question the fundamental premise of investing (markets can’t continue to provide returns of the nature it has forever....did you hear about the war....did you hear about this new technology or climate change…..blah blah). The secret to managing your emotions during investment turmoil is to take a deep breath, remember why you're invested, check any factors that will impact what you're invested in, triple check your strategy, then make a decision based on the results. 99.9 times out of 100 it’s sensible to stay the course.
Moral of the story = SAVING AND INVESTING IS NON NEGOTIABLE! Start today :)