Richard Russell of Dow Theory Letters has always been a proponent of compounding, and has written a piece on it which you can find on his website. If only I had taken his advice 12 years ago when I first started reading his letters, I would be much wealthier than I am today.
Trading and investing are very hard. The sad truth is that most people don’t make much money out of it. With a lot of hard work and dedication you can do it, but after nearly 20 years of battling with the markets, I would have to agree with Russell that “compounding is the royal road to riches.”
If you’re comfortable with a company’s ability to keep pumping out dividends and you can compound your dividends (i.e. reinvest them back into shares), you can ride out a lot of the volatility with a clearer mind.
Here is an example: If five years ago you had $100,000 dollars to invest and you decided to put it in a bank account that compounded interest at a daily rate, using the RBA cash rate less 25 basis points, you would have $119,834.67 by now.
If you bought $100,000 dollars’ worth of Telstra five years ago at a price of $4.14 (currently at $3.37) you would have collected $37,197.16 worth of dividend cheques. However, if you spent that money on flat screen TVs, paying the mortgage and holidays to Bali, you would have had a good time but your investment would now be worth $81,398.98.
If, on the other hand, you put $100,000 into Telstra at $4.14 five years ago and invested the dividends back into Telstra shares, your total holding would be worth $126,624.38. And that’s despite Telstra being 18% lower than when you bought it.
If you assume that Telstra maintains the same dividend and the share price goes nowhere, by 2016 your holding would be worth $174,988.80.
Pretty powerful stuff, which should make you think long and hard about your approach to investing/trading. If you have a good job that pays your mortgage and expenses, make sure you compound your dividends. Did I just hear all those baby boomers (like my mum) say, “I need to live off my dividends!”
You see, there’s the rub. Most of the Western world has terrible demographics. Europe’s are horrific and China’s aren’t great either. With aging populations, you have swathes of the population deleveraging, selling second properties, selling shares, needing income and becoming more risk adverse.
On top of that, we have Western governments (think UK, US and Europe) either deleveraging (austerity) or on the verge of doing so. Also, we have a world financial sector, particularly in Europe, that is also deleveraging, which means less credit flowing around the system. These will be major headwinds for growth.
On the flip side, you have countries like India and Indonesia with fantastic demographics, where the majority of the population is under 30 years of age. You also have central banks willing to print money and lend a hand at a moment’s notice. It is deflation versus inflation.
Back to compounding again: There is a downside, because it works in reverse. If you have ever juggled several credit cards at 18% or had a massive mortgage over your head, you know what I am talking about; it is very hard to get out from underneath a blanket of debt.
I have known some very wealthy people who have lost 30 years of work in the space of 12 months, due to too much leverage and debt.
This is the exact problem that Europe, the US, Japan and the UK have. They have been living beyond their means for so long and piling up mountains of debt that it is compounding at a rate of knots. This is why, when interest rates start rising past a certain point, as they did in Greece and Portugal, and as they are doing in Italy and Spain, the market loses faith in your ability to fund your obligations.
The problem with governments is that they like to be elected and they don’t like making the tough decisions until it’s too late. I read the other day that governments, unlike traders, don’t like to take the first cut and tend to let a bad position run until it’s too late. I couldn’t agree more.
So if you have a good job or business that pays your expenses, do some compounding. Do it for your kids – they will thank you in 20 years. Stay out of debt, because your local government sure as hell won’t.
Tom Lovell is an independent strategist, trader and adviser with boutique advisory firm Pulse Markets and is the author of Lovellslandscape. His note is prepared for general information only. It does not have regard to a reader’s specific investment objectives, financial situation and/or his/her particular needs regarding the appropriateness of investing in any securities or investment strategies discussed or recommended herein.