[This is a guest post from Michael Episcope, co-founder of Origin Investments which provides real estate equity funds to individuals. Origin Investments has been a paid advertiser on this site, however, this is not a sponsored post.]
The secret to growing wealth is not only making wise investments but also putting earnings to work to generate even more earnings. Money grows faster over time. When interest, dividends and capital gains on investments are left to accumulate, they grow exponentially–earning interest on not only the original investments, but also the accumulated earnings.
Calculate Compound Interest with the Rule of 72
A useful shortcut to help calculate the rate of compounding at a given interest rate or expected investment return is the rule of 72. By taking the interest rate or the expected return and dividing it by 72, the result is the number of years it will take to double your money. Using this formula, a 9% return will double every 8 years. (72 divided by 9=8)
Even a single percentage point more in annual returns add up to big dollars when you do the math. For example, over 35 years a $1 million investment portfolio generating gains of 6% annually will be worth $7.69 million, while a 7% annual return will generate a portfolio value of $10.68 million. That’s a difference of 39%.
Albert Einstein is said to have called compounding the eighth wonder of the world. Whether or not that’s true, it’s clear that keeping your money working at all times and making money on your money is the key to getting and staying wealthy. By making a few portfolio tweaks or managing cash more effectively, nearly every investor can find a way to generate another 1% to 2% annually on their portfolios. It requires discipline, but the steps are simple:
4 Ways to Accelerate the Power of Compounding
#1 Focus on asset classes with high expected returns
Portfolio optimization is a tool used by virtually every wealth manager to create risk-adjusted portfolios, but it comes at a cost by trading volatility for return potential. That’s because portfolio maximization doesn’t focus on maximizing long-term wealth, but rather minimizing long-term loss—For that reason, many portfolios are “over-diversified” with asset classes that are included to lower volatility.
Instead, Yale’s endowment has assets in both the public and private markets to optimize returns. To be clear, the Yale portfolio is highly diversified across various asset classes, each with the potential to generate sizable returns. It’s this strategy that has helped Swensen achieve annualized rates of return in excess of 12% over the last 30 years. Alternative investments such as real estate and venture capital played a key role in generating these returns.
#2 Scrutinize every fee
Investors pay fees directly to wealth managers or investment accounts, and indirectly to managers of the underlying assets. The fee for wealth managers today is somewhere between 0.3% and 1.0% on assets under management. To find lower management fees, consider re-negotiating or using a robo-advisor. Robo advisors such as Betterment and Wealthfront provide similar asset management services as traditional advisors but for a fraction of the cost.
Moving beyond advisory fees, pay close attention to investment vehicles and how their fees are structured. Passive investing has proven to beat active investing time and time again, but finding the lowest cost provider is essential. Are you in a Vanguard index fund paying 0.1% or a mutual fund paying 0.6%? Switching is simple and easy.
It’s often the hidden fees we don’t see that are the ones that destroy returns the most. The race to low fee or no fee solutions has forced companies like Robinhood to find other ways to fee customers. No one works for free and companies must make money so beware of these marketing tricks. Don’t penalize a company for putting their fees up front and center. A 1% fee can sometimes be a lot less expensive than free.
#3 Manage cash appropriately
Michael Episcope
Cash is king, but too much of it can stink up a portfolio’s return potential. Cash in an investment portfolio can drag portfolio returns down substantially because it earns next to nothing. If 20% of a portfolio is in cash, then the other 80% must work even harder to achieve your portfolio return goals. Determine how much cash you need and make sure the rest is invested appropriately, even if it’s just in an overnight money market account earning 1 or 2%. If your cash is sitting in your checking or savings account, chances are that you are earning less than 0.25%.
The biggest mistake investors make when committing to closed-end funds is setting aside their commitment in cash. In many cases, it can take years for the manager to call this capital and that’s a lost opportunity. This commitment needs to stay invested until it’s called. Over the short term, you may realize some downdrafts, but the potential funding shortfall can be easily managed by maintaining a healthy cushion in your liquid portfolio. On the back end, make sure distributions are immediately invested instead of just sitting in your bank account. In the long run, managing money in this way will reap the greatest portfolio benefits.
#4 Invest for the long-term — Set it and forget it
It’s not about timing the market but how much time you are in the market that matters. Generating a steady 7% return and managing your capital in a tax efficient manner is far better than chasing short term returns or throwing darts at the wall trying to guess the daily ups and downs of the market.
Consider this: from 1998 to 2017 the stock market generated a 7.2% annualized return. If you missed the 20 best days of those 20 years, your return would have been only 1.15%. That’s the difference between having $1,256,950 and $4,016,943. No one knows when those best 20 days will happen, which is why staying invested matters.
No portfolio grows at a steady 7%, but over the long run, the right assets managed appropriately can be optimized for a predictable expected return. The danger in optimizing a portfolio, though, is to focus on minimizing long-term loss rather than maximizing long-term wealth. Wealth managers often diversify away risk so much that they also diversify away the ability to make any real wealth. If you have a 30-year time horizon, why are you investing in bonds? Moving that money into alternatives with high return potential is a far better solution so long as you can identify the right funds.
By combining traditional assets with high potential alternatives, investors can make long-term plans that give them the best options for appreciation. An adviser may have 50 to 100 relationships but you have only one. Stay on top of your portfolio and don’t be afraid to challenge the status quo because it’s your nest egg that’s on the line. The job of the advisor is to not lose you money, but the absence of loss is not gain. Work with them to craft a plan that not only preserves your wealth but also affords you the ability to build wealth. Finding that extra 1-2% in returns is fairly easy if you follow some of the steps outlined above and can pay huge dividends down the line.
Do you agree with these recommendations for increasing investment returns? Why or why not? Comment below!
Regarding point 1 – focus on asset classes with high expected earnings.
Agreed that to increase return, you need to lower the more stable lower return lower risk assets, but
A. The lower risk lower return assets have a place which is separate from looking entirely at returns. A portfolio should be constructed around risks – risk of not earning enough is one, but so is running out of money due to a higher risk portfolio during drawdown, or risk of panic-selling when you see your life savings steadily drop 50% not knowing when it will stop dropping or if it will be a Japan type scenario or a 1966 type scenario where it too a couple of decades to recover.
B. On the subject of alternative investments, I would like to offer the 2 links below.
Personally I think you could just have left out the alternative investments example entirely, I think it clutters and fogs up the point that you are trying to make.
https://awealthofcommonsense.com/2019/02/simple-vs-complex-2018-edition/
https://awealthofcommonsense.com/2019/02/how-to-wreck-a-pension-plan-in-3-easy-steps/
I concur with J.D. regarding alternative investments.
Swenson is brilliant and was very early into alternative investments. Essentially, as the two links you provide illustrate, most everyone else in the endowment field is now chasing Swenson, not only to no avail but to some pretty poor results over the past decade or so.
To be successful, investors need to understand what they own., e.g. how does a stock or a bond change in price from day to day? If they don’t they understand what they invest in, they are likely unprepared to handle volatility.
CFAs can be challenged to understand how alternative investments “work” and to accurately track their performance.
Readers of this blog are well advised to read both of the links from the “A Wealth of Commonsense” blog that you provided. Ben Carlson, CFA, is an excellent writer. Investors should subscribe to Ben’s blog linked below.
https://awealthofcommonsense.com/
The absence of loss is not gain is a brilliant line and right to the point.
That fact of a 7% return dropping to around a 1% return if you miss the 20 best days in the past 20 years in the market is quite eye opening. No one has a crystal ball which days are good (or bad) so the only way to take advantage is to be always invested and not trying to time it.
It was incredible marketing genius whoever came up with the basis point for fees. It seems like such a small number and the reason why most people gloss over it but it can mean 6 figures (or more) in fees over a typical portfolio building phase.
Statements like “Your return would have only been X if you had missed the best Y days in the market” ignores the flip side of that coin: “Your return would have been a stellar X if you had missed the worst Y days in the market.” That logic cuts both ways equally. By itself, it’s not a valid argument against market timing.
I think you are missing the point. What are the odds you can perfectly time the best and/or worst days of the market? Market timing has proven over and over not to work. I stand by the notion that time in the market is how one achieves investment success and not timing the market.
Whether the market can be timed or not effectively is another discussion. The point is that the above type of statements do not mean anything practically useful and are not a valid argument against market timing. The statement could easily be reversed to say something like “Had you missed the worst 10 days in the market, your annual return would have been 31%.” That’s no more useful than someone pointing out that buying Amazon in 2000 would have been a great move; it can only be known in hindsight.
I don’t follow your logic. Saying that you would have made 31% by missing the 20 worst days over 20 years is advocating that it’s somehow possible to do that . This is purely an illustration of probabilities. What are the odds you can perfectly pick 20 of the best or worst days out of more than 5000 trading days over 20 years? Again, it’s the argument that crystal balls don’t work.
Here’s a nice summary of this issue. Timing the market is, of course, a loosing proposition
https://ofdollarsanddata.com/even-god-couldnt-beat-dollar-cost-averaging/
Statements like “Had you missed the best X days…” are no more an effective indictment against market timing than statements like “Had you missed the worst X days…” are an effective exoneration of market timing. Both are factual but meaningless from any kind of practical standpoint. Hence, both types of statements should be expunged from such discussions.
Main reason why I got rid of my advisor was diversifying so much to minimize gains. Maybe that was okay for someone retired, but I tired of minimal gains that lagged the S&P while paying 1% of assets. Invest in quality and hold while minimizing fees. Be greedy when others panic.
Fees will get you. Using a fee comparison calculator is what convinced me to learn this stuff. I was starting with basically no knowledge but figured that I could dedicate some time to acquiring the know how.
There is a lot I would do for a million bucks, and learning how to manage our investments is one of those things.
Use one of those fee comparison sites like dinkytown. See how hard fees hit over a 30yr career. The difference between DIY and a 1-2% manager is astronomical!
Yes, I find, when teaching about investing to our residents, is the fee comparison graphs that really gets their attention.
Read a study yesterday where they said rebalancing has no advantage over buy and hold but most rebalance to lower the risk
Yes, rebalancing has historically not done much for returns, but it has tended to reduce risk (i.e. improve risk-adjusted returns).
studies show endowments do not beat passive investing
for us a waste of time
Lastly your objective is to achieve your goal, not to shoot for the highest absolute return; especially nearing retirement
Where did you get this data? “Consider this: from 1998 to 2017 the stock market generated a 7.2% annualized return. If you missed the 20 best days of those 20 years, your return would have been only 1.15%.”
I have never seen this before and it is quite eye opening. I am interested to know if it is accurate.
Thanks!
Please see my above comment regarding these kinds of statements. At best, they’re pointless and at worst, they’re misleading.
I understand the flip side. But my question remains. Is this statement accurate and if so where did he get the data?
It also makes me wonder what taking out the 20 worst days of the year over the past 20 years would do. My suspicion is that it would change that 7% return to something in the 3 or 4 digit percentage return.
The source is highlighted in that paragraph of the article. Just click on the highlighted blue letters. I couldn’t paste it here for some reason. Thanks for your comments.
I’m curious as to how someone identifies overdiversification. That seems a little nebulous of a term to me.
In # 4 Michael Episcope misuses the term Closed End Fund. Many closed end funds are not real estate funds nor are the long term or alternative investments.
I own 4 Closed End Funds all of which are stock funds which trade daily……..Gordon
It’s not actually misused. It’s a common term in the private equity space and describes funds that raise a finite amount of money and invest it over a specific period of time, typically 8-10 years. I can see how it can be confusing though seeing as it is used in both the public and private markets. Thanks for reading the article.
I would argue that the best way to accelerate compound interest is to increase your savings rate. It requires no additional knowledge of factor investments. It may force you to decrease your spending, which in turn will decrease the amount needed to reach FI. It requires no time following the latest data on market trends and asset allocation. It’s that simple. Increase your savings rate.
Agree with this 100%. My portfolio is a US REIT, NASDAQ 100 fund, Vanguard US stocks fund, Vanguard global. There is diversification but amongst high fliers. All have ability to push high returns. Long time frame.
Soooo…..100% publicly traded stocks. Seems diverse.
RE #4. From Brett Arends column today in MarketWatch:
Yes, certainly, the biggest “up” days on the market have historically accounted for a big chunk of long-term returns. “One of the most common rhetorical bulwarks in the defense of buy and hold investing is to demonstrate the effects of missing the best 10 days in the market, and how that would affect the compounded return to investors,” Cambria Investments manager Meb Faber pointed out in a recent research paper.
But, he warns, “This is perhaps one of the most misleading statistics in our profession.” The reasons? Most of the biggest “up” days took place during bear markets, when the smart move was to be on the sidelines, he says. Oh, and missing the worst days was just as good for your wealth as catching the best ones, he found. From 1928 through 2010, he calculated, the 1% best days gained you, on average, 4.9% each. What about the worst 1% of days? They cost you about 4.9% each.
You guys really don’t like that statement, despite its truth. That’s okay, there are plenty of better reasons why timing the market is a fool’s errand.
It’s just a silly argument, even though it’s strictly accurate. There are far better ways to argue against market timing.
Who made that quote that was something like ” with an ever increasing total market the only people who lose money are those that dance in and out.”
They way I look at it is that you have to accept the bad days if you want the good days because we do not know when they are going to happen. So set it and forget it.
The thing is, there are far more good days than there are bad days. Over the long time the market mostly goes up. Therefore the statement is still true.
I respectfully disagree that you should be all in stock with a 35 year horizon. If you’re interested in reading about the utility of bonds in a portfolio take a look at “Why Bother With Bonds” by Rick Van Ness. Pay particular attention to pages 124-127. Also take a look at this article referenced by the book (http://www.norstad.org/finance/risk-and-time.html) regarding risk and time in the market. “Because of the effect of compounding, the stand deviation of the total return actually increases with the time horizon. Thus, if we use the traditional measure of uncertainty as the standard deviation of return over the time period in question, uncertainty INCREASES with time horizon.” In other words, time in market does not reduce your risk.
Good point about expenses, but let’s pursue it. Those who have been paying attention to the odds on active management beating indexing have ruled out active funds. There is nothing preventing mangers from following rules based passive approaches. That huge group of managers trailing the indexes after fees and tax INCLUDES these so-called “passive” managers.
Do low cost indexing and ignore the hype about special sauces brought to you by genius managers for “only” x% of your assets.
Those who go all low cost index are paying dollar weighted average expense ratios of under 10 basis points. If they omit international indexes, they are under 5 basis points.
So 0.3-1% of assets means paying an advisor anywhere from 3X to 20X the cost of the funds. For a contribution of at best zero value.
First step- buy low cost index funds. Second step- reduce your advisory costs to zero.
Then save more, spend less and ignore the markets.
News Flash:
Per Bloomberg News 12/2018, the University of Texas endowment surpassed $31 Billion (thanks to oil revenues) thus moving into 2nd place ahead of Yale U.
Hook’em Horns
Point 4 is where it all hits home. Very true.
Time in the market is way more powerful than timing the market.
Great advice. Thanks for sharing.
#4 Invest for the long-term — Set it and forget it
It is really difficult to achieve this goal. One paradigm is that when let’s say a stock or cryptocurrency is increasing, you never know that when is the right moment to sell it. We know that many people regret selling at some certain point because there is always a possibility that the asset might fall down. So how will we decide?
You know there is a way to invest such that you don’t have to make that decision, right? A fixed asset allocation of low cost, broadly diversified index funds. No crypto. No individual stocks.