Thursday, October 4, 2018

Use these tools within your control to get rich

The ultimate goals of everyone reading this site is to retire wealthy and to stay retired. Financial independence provides flexibility, freedom and a lot of options in life for you. Getting there is usually the challenging part.

I have been on a quest to reach financial independence ever since I graduated college in 2007. I have spent at least a few hours per day, every day, for almost a decade now dreaming of, planning for and working towards my dividend crossover point. The dividend crossover point is the situation where my dividend income exceeds my expenses. While I am very close to this point today however, I also want to have some margin of safety in order to withstand any future shocks that might come my way.

In the process of thinking about how to reach financial independence, I have spoken to a lot of others who are working towards financial independence. I have come up with a list of a few tools that these people have used to get rich. These are tools that are within their control. While outcomes are never guaranteed in the uncertain world of long-term investing, taking maximum advantage of things within your control tilts the odds of success in your favor.

These levers are common sense, and are at a very high level, but I have found that they are super important. If you ignore those levers however, chances are that you may not reach your goals, even if you are a more talented stock picker than Warren Buffett.

I have found that the only levers within your control as an investor such as your savings, investing in something you understand, time you have, keeping costs low for taxes and commission/fees.

1) The most important thing for anyone that wants to attain financial freedom is savings. If you do not save money, you will never have the capital to invest your way to financial independence. As a matter of fact, under most situations, you have more control over your savings rate, than the returns you will earn as an investor. If you earn $50,000 per year, you can accumulate $10,000 in savings within one year if you save 20% of your income. In this case, your annual spending is $40,000/year. The $10,000 you saved will be sufficient to pay for your expenses for 3 months.

If you figure out a way to cut your expenses and to save 50% of your income, you will be able to save $25,000 in one year. This means that after one year of working and saving, you can take an year off. If you are like my friend Jacob from ERE, and you manage to save 80% of your income your spending would be $10,000/year. This means that after working for a whole year, you are accumulating enough money to last for 4 additional years. After five – six years of working and saving aggressively, you will be able to retire because you would have accumulated somewhere close to 20 – 24 times your annual expenses. And the best part is that all of this ignores investment returns. The point is not to focus on absolute dollars, but on the savings percentages. The point is that you have a higher level of control over how much you save, and this has a higher predictability of success when building wealth, than the returns on your investment. Unfortunately, future returns are unpredictable. Dividends are the more predictable component of future returns, which is why I am basing my retirement on dividend income.

This is why I have found it important to keep my costs low, in order to have a high savings rate and accumulate money faster. I have been lucky that I have essentially saved my entire after-tax salary for several years in a row. Besides keeping costs low, I have achieved that by trying to increase income as well. ( when you save a lot and invest in dividend paying stocks that pay dividends, you get more income)

2) The second important thing you have within your control is the type of investments you will put your money in. It is important to understand that despite a history of past returns, future returns are not guaranteed. You have no control over the amount and timing of future returns – the best you can do is to invest in something you understand and something that you will stick to no matter what. In my case, I invest in dividend paying stocks with long track records of regular annual dividend increases. Others have made money by investing in business, real estate, index funds, bonds etc. The important thing is to find the investment that works for you, and to stick to it.

I do this, because I have found that dividend income is more stable than capital gains. Plus, I want to only spend earnings in retirement, not my capital. With this type of investing, I am getting cash on a regular basis, which I can use to reinvest or spend. It is much easier to generate a return on my investment, and to stick to my investment plan, when I am paid cash every so often. If I invested in hot growth stocks, I would be subject to huge fluctuations that would impact how much I can spend in retirement. So I would be less likely to stick to my plan. Dividends are not guaranteed, but they are more stable and more reliable portion of total returns than capital gains. Investors who rely mostly on capital gains face huge risks because most of their returns will be dependent on the mood of Mr Market who may decide to value companies at anywhere from 5 to 100 times earnings. If you expect to sell stocks to fund your expenses, you would be in a lot of trouble if you sell at 5 times earnings because you will be eating up your capital quickly. In addition, you will be in a lot of trouble if Mr Market decides that the company for which you paid 25 - 30 times earnings and which grows your share of its income is now worth 10 - 15 times earnings. This is precisely what happened between 1968 and 1981 for US stocks as represented by S&P 500 – the P/E ratio contracted from 18.20 to 8.10, while earnings per share increased from $5.72 to $15.18. As a result, S&P 500 barely went up in nominal terms from $103.86 to $122.55 over the same 13 year period. Almost the entire equity returns over that period were derived from dividends, which increased from $3.04 to $6.83. (source).

3) The third important tool at your disposal is your ability to compound your investments over time. You have some control over the amount of time you will let your investments compound. Over time, a dollar invested today, that compounds at 10%/year should double in value every seven years or so. This means that in 28 – 30 years, the investor should have roughly $16 for each dollar invested at 10%. Of course, if the investor doesn’t allow their investments to compound, they would be worse off. Many investors are sold on the idea of long-term compounding. Unfortunately, a large portion end up trading far too often for various reasons. One reason is fear during a bear market. Another is the desire to take a quick profit, without letting compounding do its heavy lifting for them. I have observed people panic and sell everything when things sound difficult. Another reason for selling is the attempt to time the markets or the attempts to replace one perfectly good holding for a mediocre one.

In most situations, the investor would have been better off simply holding tight to the original investment. For the past 8 - 9 years of writing on my site, I have seen someone mention that stocks are at a high level almost every single month. Like this successful investor, who believed that stocks were expensive in 2009. Almost no one can sell at the top and buy at the bottom – so don’t bother timing the market. Most investors who claim that they have avoided bear markets do so, because they are often in cash. Therefore, they miss most of the downside, but they also miss most of the upside as well. A third reason for frequent trading is because the investor is told that some other group of stocks/strategies/ has done better recently, which somehow is a good reason to sell their original holdings. Again, your portfolio is like a bar of soap – the more you handle it, the smaller it gets. The best thing you can do is find a strategy you are comfortable with, and then stick to it. There aren’t any “perfect” strategies out there, so if you keep chasing strategies you are shooting yourself in the foot. As a matter of fact, you would likely do better for yourself if you buy long-term US treasuries yielding 3% and hold to maturity, than chase hot strategies/sectors/investments. So find a strategy, and stick to it through thick or thin.

4) The other important factor to remember is to keep investment costs low. What does that mean? It means to keep commissions low. When I started out, I paid a zero commission for investments. I then switched to other brokers and tried to never pay more than 0.50%. But this is too high – there are low cost brokers today, which charge little for commissions. Try to keep costs as low as possible, because that way you have the maximum amount of dollars working for you.

It also means to make sure to minimize the tax bite on your investment income as well. I used to have an acquaintance who chose to pay tens of thousands of dollars more in taxes every year than they had to. They did this because they didn’t want to learn about taxes. This was really surprising to me, because this person claimed to be super frugal. Once I really spend time to learn how to minimize the impact of taxes on my investments, the rate of net worth and dividend income growth increased significantly. I have calculated that a person who maximizes tax-deferred accounts effectively in the accumulation phase could potentially shave 2 -3 years for every ten years of saving and investing.

In order to keep costs low, the amount of fees you pay to an adviser should be eliminated. Most investment advisers out there do not know that much more than you do. If you decide to educate yourself on basic finance, you will likely know as much as most investment advisers ( most of whom are salespersons). It makes no sense to pay someone an annual fee of 1% - 2% per year on your investment portfolio. The long – term cost of 1% - 2% fee compounds over time to a stratospheric proportion. It makes no sense to have someone who doesn’t know that much charge you 1% - 2%/year merely for holding on to your investments ( because that’s what they are doing).

Thank you for reading!

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