Imagine a black box.
Your job is to earn and save as much money as you can. You put the cash saved into the black box…into your compounding machine. Once you put the cash inside the box and close the lid, the magic starts to happen.
Inside the black box the most powerful force in the universe gets to work and your money starts to grow prodigiously. You start with a few thousand pounds and end up with hundreds of thousands, maybe millions.
If you are a bit lazy (and who isn’t?) and yet still want to get rich (and who doesn’t?) then this is The Path for you. We want our money to do as much of the work as possible for us. Yes, we are going to have to save hard…but the earlier we get started, the more of the heavy lifting that compound interest can do for us.
What powers the machine?
The results generated by your Compounding Machine will be driven by:
- The % of your after tax income you put into the box
- How quickly you get the Compounding Machine started
- What asset allocation (i.e. the mix of assets) your Compounding Machine runs on
- The fees that are taken out of your box
- Which fund(s) you choose
All of these elements are important but please note the order I have put them in.
The savings rate is vital. At a 50% savings rate, you will go from broke to financially independent in about 18/19 years. But, at the start of your journey, the most important thing is just to save something (anything) every month. The point is to get into the habit regardless of the amount. Pay yourself first and invest on auto-pilot.
When should you start? Well, the best time to plant a tree was 20 years ago, the second best time is now.
Kate’s compounding machine
To illustrate the power of starting early, let’s return to the example of Kate…a bright school leaver who gets a job aged 18. Kate does not go to university to learn how to eat vodka jelly but instead gets a job, avoids student debt and is able to start saving after 6 months.
Over the next 7 years, our heroine does well and learns stuff at work that actually helps her in life. Things like how to work hard, deal with people and use basic arithmetic. And she does not spend all her salary on
shit stuff. Instead she saves, paying herself first every month, setting up a direct debit to stash £167 per month for a total of £15,000 over that period.
Kate directs her monthly savings into a low cost equity index tracker, saving £2,000 per year until age 25 when she stops making contributions into her pension and never saves another penny. Kate does nothing with her pension for the next 40 years and, as a result, Kate gets the same annual return (~10%) as the S&P 500 has done over the last 100 years or so.
At age 65, Kate fires up her laptop and is pleasantly surprised to see that her £15,000 of contributions have grown to just over £1 million. True, inflation means that a million pounds isn’t worth as much as it used to be. But still…not too shabby. You can check out the maths for yourself here.
What does that look like?…BEHOLD THE MIGHTY J CURVE OF COMPOUND INTEREST:
Market predictions are a waste of time
It is traditional at this point for
some clown someone to start questioning whether 10% annual returns are realistic in future. We won’t be playing that game here. No one has a crystal ball and no one knows what future returns will be.
The bear case sounds smarter, perhaps because in most areas of life smart and sceptical people often do better. But there are no IQ prizes in investing. A 10% a year return from a stockmarket tracker fund achieved by a person with average intelligence beats a 2% return from a complex multi-asset approach achieved by someone who went to Harvard (someone should really tell hedge fund investors that).
When it comes to predicting future returns, there are 2 types of people: 1) those that don’t know and 2) those that don’t know they don’t know.
What we do know is that, using The Rule of 72, the money inside your compounding machine will double every 9 years at an 8% annual rate of return. At a 10% rate of return the money will double every 7 years. The higher the returns, the quicker your money doubles in value.
Fuelling the machine
We need to choose the fuel for our compounding machine. Just saving into a bank account is like trying to power a full size car on itty-bitty AAA batteries…you wont get very far or very fast. The same applies to bonds: they can’t power your engine, they can only act as a store of value and a shock absorber.
Gold (or commodities more widely) can act as a store of value but it does not compound, it just sits there as an inert lump of metal – it does not grow and it does not pay an income. The same goes for cryptocurrency.
To power your compounding machine properly, you invest in wealth-creating assets and that means either the stockmarket or property. The stockmarket is easiest and it goes up because every year human beings get better at making stuff, using technology and solving problems.
Once you have paid off expensive debt, the best thing to put in your compounding machine is a low cost global tracker fund (such as VWRL or VRXXB in the UK).
The J curve illustrates the huge and exciting opportunity…and also the problem.
The problem is that the first 6 or 7 years are B – O – R – I – N – G. If you are looking to investing for your excitement in life, you’re looking in the wrong place. By all means take up para-gliding, running with the Bulls at Pamplona or chainsaw juggling…just don’t expect to get that buzz from your compounding machine in the early years.
Better to think like a gardener. Once you have planted your seeds, there’s no point digging them up and looking at them every week to see how they are getting on. Be patient: the time always passes and the future always arrives.
Once you have your compounding machine set up correctly, the less tinkering, the better. I love those studies done by online stockbrokers where they analyse the results achieved by their clients and found that the ones that did the best were those that had died (and the category that did second best had forgotten their log in details).
It may sound like a small point but one of the things I like about Vanguards ETFs (e.g. VWRL) is that dividends are paid every quarter and that’s a regular morale boost and reminder that your compounding machine is working.
If you are naturally impatient, that’s fine…just channel your impatience into your career. Take a qualification, win clients, beat your targets, learn to sell. Make yourself more valuable!
Everything compounds…its not just your stash. If you are doing it right, your salary, your knowledge and your ability to solve problems should grow exponentially as you go through life. The more capital you have (not just money but social capital, reputation, ability to reach an audience) the more effective you become.
Do you really understand compound interest?
It’s important to understand the J curve both objectively and emotionally.
Objectively, the maths is the maths. There’s no point arguing with it…that’s like arguing with gravity.
But you also need to understand it emotionally. Here’s the million dollar (or pound) problem. We are monkeys programmed to operate in the here and now. Our untrained brains are well-adapted by evolution to solve the problem of what’s for supper tonight. But they are absolutely shite at focusing on saving for the long term.
So you have to use your rational mind (the weakest part of the brain) to overcome your chimp brain. This is a bit of a David vs Goliath fight…but its a fight that your inner David can win by carefully targeting his effort.
Here’s a powerful way to tell if you understand compound interest or not. Are you ready? People that understand compound interest, earn it. People that don’t, pay it.
Why you must get out of debt
Imagine that we could invest the money in our compounding machine and get annual returns of 23% per year. That means £10,000 turns into £20,000 in just over 3 years.
Impossible you say? Well, my credit card provider recently wrote to me informing me that the interest rate on any balances not paid off every month is 23%. So millions of credit card holders with debt balances have a guaranteed way to earn 23% a year.
If you are reading this and have any credit card debt, that shit needs to get paid off before anything else. If you have credit card debt, you do not go on dates, visit pubs, restaurants, shops, bookmakers, strip clubs, sports fixtures nor attend property investment or timeshare seminars. In the immortal words of Fergie: take your broke ass home. YOU GO TO WORK, THEN SLEEP, THEN REPEAT UNTIL THE DEBT IS GONE.
I recently got a call from someone asking me for financial coaching. They were telling me about their situation and said they had credit card debt…at which point I gently pointed out that I would not be taking money for coaching from anyone that had credit card debt. If you have credit card debt, pay it off first!
Being in debt is like your compounding machine being in reverse gear. Imagine you are in a rusty pick-up truck in the Arizona desert with no aircon, stuck in reverse gear with the radio playing Country & Western music as you accelerate backwards towards the edge of the Grand Canyon. That’s how bad having credit card debt is.
Why doesn’t everyone get taught this at school?
Given how important compound interest is, it’s baffling to me how few people understand it. And how few financial “experts” teach it properly.
If schools taught useful information for life (rather than conformity) they would teach the power (and the maths) of compound interest.
If all personal finance journalists / writers were genuinely interested in spreading financial literacy, they would major on this stuff rather than on coupon clipping and affiliate links.
No one else is coming to save you. If you are reading this and haven’t got your compounding machine set up yet, this is an emergency.
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