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Harness
the Power of Compounding
How
to Get Rich--Slow & Easy
Probably the
most important thing you need to know about building wealth is the power
of making regular periodic investments and reinvesting rather than
spending the profits.
The results
you’d get following this discipline are surprising. Say you start with
nothing, but decide to put $500 of your income into an investment
account every month, and you commit to letting your money ride. That
means you can’t take withdraw any funds until you’ve reached your
long-term goal.
The overall
market, at least as measured by the S&P 500 index, returned 11.8%,
on average, annually over the past 10 years. If you achieve that same
return, you’d have $114,000 after 10 years. But it gets better.
You’ll have $486,000 if you stick with the plan for 20 years and a
cool $1.7 million in 30 years.
The process
I’m describing is a combination of two powerful investing strategies:
compounding and dollar-cost averaging.
Compounding
is simply reinvesting rather than spending your profits. By doing that;
you capture the future returns on your reinvested profits as well as on
your original investments.
Dollar-cost
averaging means that your fixed monthly investment buys more shares
of a mutual fund or stock when prices are low, and fewer shares when
prices are high. For instance, if you were investing $500, you’d get
10 shares if a stock were trading at $50, but roughly 12 shares if it
dropped to $42.
Discipline
Required
The hardest part of implementing these strategies is making the regular
monthly investments. It’s easy to procrastinate adding to your account
if the market is down or if you could use the cash for something else.
The best way
to make sure that the regular investments happen is to set up an account
with a broker or mutual fund that automatically deducts a fixed amount
from your bank account every month.
While you
could do it with stocks, the easiest way to implement the strategy is
with a portfolio of well-chosen mutual funds that are likely to produce
returns at least even with the market, and if you’re lucky, beat the
market. A little goes a long way in that department. For example,
starting from zero, if you managed a 14 percent average annual return
instead of 11.8 percent, you’d have $2.8 million after 30 years
instead of the $1.7 million I mentioned earlier.
Once you’ve
selected your fund portfolio, buy equal dollar amounts of each fund.
Then add to each fund equally every month. Periodically you’ll have to
replace some funds that have gone bad, but be sure to avoid the
temptation to take money out of your portfolio in the process.
Finding
Funds
Here’s a method for finding suitable mutual funds using
Morningstar’s free, user-friendly, fund screener. It looks for
relatively low-risk funds with a solid track record of beating the
market. While past performance doesn’t guarantee future results, in my
experience, such funds are likely to continue their winning ways.
Start from
Morningstar’s homepage (www.morningstar.com)
by selecting Funds,
and then Mutual
Fund Screener.
First, limit
the field to U.S. stock funds by picking Domestic Stock in the Fund
Group category. That requirement rules out bond funds and funds
focusing on foreign stocks.
Then, select Manager
Tenure of 10 years or longer. Long-term returns will be our primary
selection criteria and the data is meaningless if the person responsible
for the returns is no longer at the helm.
Next, specify
a $3,000 maximum initial purchase requirement. Keeping the
requirement low lets you diversify by buying several funds. Don’t be
discouraged by a $3,000 minimum if you want to start out smaller. Many
funds have lower minimums for investors initiating automatic investment
plans (AIPs). For instance, the Tocqueville Alexis fund advertises a
$3,000 minimum but only requires $100 for AIP investors. After the
initial purchase, most funds require minimum monthly additions between
$50 and $250.
You can find
each fund’s minimum purchase requirements on Morningstar’s
“Purchase Info” report. Beware; some brokers have different
requirements than the fund advertises. In some instances, you may find
it best to deal directly with the fund rather than going through a
broker.
Sales loads
are commissions that mutual funds pay to financial advisors and others
to recommend their funds. These commissions reduce your returns and
there’s no point in paying them if you’re choosing funds on your
own. Thus, require “no-load funds only.”
Morningstar
rates funds based on their historical return vs. risk performance. The
ratings vary from one to five stars, where five is best. This strategy
hinges on picking the funds with the best historical records, so require
“five-star funds only.”
Morningstar’s
risk rating compares each fund’s historical volatility to
similar funds. The ratings range from low to average to high. Avoid
volatile funds by setting up the screen to allow only risk levels of
“average or better.”
Finally,
specify that passing funds’ returns equal or exceed the S&P
500’s average annual returns over the past 3, 5 and 10-years.
It’s crucial that a fund’s return meet all three requirements.
Otherwise, you’ll get funds whose strong performance in a particular
period masks overall underperformance.
The Funds
The screen turned up 14 funds when I ran it last week. However, seven of
those were closed to new investors (see Purchase Info report), leaving
seven viable candidates. The average annual returns of those seven funds
averaged 13.4% over the past 10 years.
The top
performer, Meridian Growth, scored an 14.5% average annual return. The
remaining funds, with returns in the 12 to 14% range, were Federated
Kaufmann K, Fidelity Contrafund, Gabelli Equity Income, Mairs &
Power Balanced, TCW Galileo Dividend Focused, and Tocqueville Alexis.
Even the best
mutual funds go through periods of underperformance. So even though I
recommend periodic weeding out weak performers, don’t be too fast on
the trigger. At the most, reevaluate your portfolio annually, and
waiting two years is better.
published 12/12/04 |
