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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

 

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