3 charts that unlock the secrets to building wealth
All it takes is a basic understanding of the power of compounding, patience and perseverance
I received an email from a reader the other day outlining the approach he and his wive were taking to transition to retirement. The reader wrote:
Unlike you, I am further down the retirement track! I am now 67 and have been drawing a "pension" from our SMSF for a number of years, I put "pension" in quotes because my wife doesn't like the term, she prefers "income stream"!
I take the minimal 5% from my part of the SMSF (tax free) which supplements my part time work as a software developer. I have tried to convince my wife to retire, but she is hanging on 'til she turns 65 at the end of next year. Although she salary sacrifices, I have tried to convince her that it will make very little difference, it is not really possible to make a significant increase to your balance in the final years, unless you can make a large lump sum contribution. She would be better to drop from 4 days a week to three, stop extra contributions, which will give her a similar take home pay!
This got me thinking about how misaligned conventional wisdom is to the realities of building wealth. Young people are told to take risks in both life and in investing. The rationale given is that they have plenty of times to make back any money lost in the market or money spent enjoying themselves. Worrying about things like retirement can wait.
I certainly understand this view. And it aligns with our natural tendency to procrastinate. More importantly it is what we all want to hear when we are young and getting that advice. Those giving the advice are often older and it aligns with their nostalgia for youth and freedom.
I am not here to ruin the party. But from a financial perspective that advice flies in the face of the basic math of building wealth. I created a chart that outlines a hypothetical investor that saves and invests $10,000 annually for 40 years. In my hypothetical scenario the investor receives a steady return of 8% per year. Obviously, this smooth return is not representative of the gyrations of the market but it is an achievable figure with a diversified portfolio over the long-term.
The best description of the impact of compounding that I’ve heard is a snowball rolling down a snow covered hill. The snowball starts small but picks up more snow as it continues traveling down the hill and gets bigger and bigger. As the surface area of the snowball increases it picks up even more snow with each rotation. That is the power of compounding.
We can see this in the chart. The total wealth generated is $2,590,565 over 40 years. But over the last 10 years 52% of the total wealth is gained. If you take nothing else out of this article it should be that starting as early as possible is the best way to build wealth.
The next chart shows the source of your gains in wealth each year between the $10,000 that is saved and the returns earned on your portfolio. In the beginning of this period most of the increase in wealth comes from savings. And this makes sense because your portfolio is small in relation to the amount that is saved and invested.
In year 10 this starts to shift and the wealth increase from returns starts to surpass savings. As you get to the end of the 40-year period almost all of the increase in wealth comes from returns. This gets back to point raised in the email. As you get older and your portfolio becomes larger the amount you save has less and less of an impact on your outcome.
Framing the decision like that motivated me because I wasn’t thinking about what my sacrifice would get me in 40 years. I was thinking about how if I could grow my salary I wouldn’t have to dedicate more of my salary to savings. I could spend it on what I wanted. And in many ways I’m benefiting from that decision now.
The next chart shows the impact on the outcome received of losing $10,000 during each year of the 40-year period. You can consider this either losing the money on some speculative investment that you take a punt on or not being able to save money.
In year 1 if you don’t save the money or lose the money on a speculative investment the impact is staggering. You would have over $200k or close to 8% less money at the end of the period. If you do the same thing in year 35 it only impacts your outcome by $14,683 or 0.39% less money.
This is another area where the conventional wisdom about taking risks when you are young doesn’t hold up to scrutiny. If you want to take a punt and put $10k in some speculative share it is far better to do it later in life than right off the bat.
This also demonstrates the implications of not saving money early in life. And I want to be clear that life is about more than money. Taking a year off to travel when you are young can be a life changing experience. But whenever you make a decision it is important to understand the trade-offs. And the trade-off in this case either is meaningfully less money at the end of the savings period or having to save even more later in life.
Parents who are trying to improve their children’s life may want to consider the lessons from these charts. Investing even a small amount of money when children are young can change their lives significantly. My colleague Shani wrote an article on ways to invest for young children which provides some great tips.
Final thoughts
Saving and investing has the power to transform lives. And it doesn’t have to be complicated and it doesn’t require you to be an expert investor. All it takes is a basic understanding of the power of compounding, patience and perseverance. All things in short supply. As Warren Buffett said, investing is simple, but not easy.
I would love to hear your thoughts or questions. Email me at [email protected]
