Three simple ingredients for building wealth

People tend to overcomplicate things, don’t they? One of my favourite cookbooks is Hugh’s Three Good Things by Hugh Fearnley-Whittingstall. The premise is simple. Just put three good things together on a plate, and the result is greater than the sum of the parts. 

When it comes to investment planning, the same principle applies, no matter the goal. Simple tends to beat complicated. 

If Hugh were serving up our investment process on a plate, the three ingredients would be time, diversification, and low cost.

Time 

When mapping out your investment goal, you need to have a grasp of the timeframe. You may not know what it is yet. If it’s a dollar value, start at the end and work your way back. For example, if using the InvestSMART Retirement Calculator, put in a figure you believe you will be comfortable retiring on.  

For a guide, view this great article where Scott Francis walks through The Association of Super Funds Australia’s guide to the amount you’ll need to retire.  

The reason why time is so important is that it shapes the level of risk we can take in a portfolio. Whenever you look at a managed fund or investment option, the recommended timeframe isn’t just a regulatory box ticking, it’s vital to understand the level of risk involved and to prepare yourself for how long you should expect to hold the investment. A high-growth investment will typically have a timeframe of 7 years. 

Time also helps us smooth out volatility. Whilst we can’t avoid it, it's important to see rough periods through so as not to interfere with the power of compounding. 

Diversification 

Professor and Nobel Prize-winning economist Harry Markowitz made diversification cool. In the 50s, he developed Modern Portfolio Theory which is widely used by investors and advisors to this day. In short, Markowitz discovered that it was the composition of one's investment portfolio and not the actions of an individual investment that determined its success. 

Through diversification, Markowitz proved investors could lower the overall risk of their portfolio whilst still achieving satisfactory returns. Diversified portfolios are built off the back of this work, including the InvestSMART Professionally Managed Accounts. 

Fees 

The focus on fees isn’t about finger-waving at the greedy fat cats of finance. It’s about what you end up with in your pocket.  

Research shows that higher fees do not reflect better performance; in fact, it’s quite the opposite. My colleague, Alan Kohler, summed it up wonderfully in his article, The Great Investment Fee Scam. 

Next time you use an investment calculator to see how quickly you can hit your goal or how much you’ll have after a few years, adjust the return by 1%. At first, the difference is minuscule, but compound that over a few years, say seven, like a high-growth portfolio, and the difference is dramatic. 

If you focus on nothing other than these three core ingredients, you’ll be better off than most. The only thing you’ll need to do is ignore the noise tempting you to chop and change, and be stingy on costs (just like my colleagues who hit up the steak night at the Local Tap House in St Kilda every Wednesday).