Excerpts from The Two Essential Elements of Wealth Accumulation

How to make them work for you

Wealth is not acquired through addition. It is acquired through multiplication……According to statistical studies, two factors are most important in achieving wealth:

The number of years that an individual has been consistently saving and investing
The proportion of funds, on average, allocated to higher return investments such as stocks.

This does not mean that stocks should always be held regardless of price and risk levels. ….. Most have achieved their fortunes by compounding a moderate but consistent rate of return over a long period of time.There is a simple mathematical explanation for why these two factors are most important in building wealth:

Future Wealth = Current Wealth x (1+k)T

Where k is the annual rate of return earned on current wealth, and T is the number of years that wealth is allowed to compound in value.Wealth accumulation is exponential. At a 10% annual rate of return, $100 compounds to $259 over 10 years, and to $673 over 20 years. At a 15% annual rate of return, $100 compounds to $405 over 10 years, and to $1637 over 20 years. So both the rate of return, and the length of compounding have enormous leverage in creating future wealth.Simply stated, if your goal is to accumulate a significant amount of wealth during your lifetime, you must first save something, and then exercise some amount of control over one of two factors: your long-term rate of return, or the time horizon T over which you compound your wealth.

Increasing the long-term annual return

For most individuals, the best way to increase the annual return over time is to allocate a larger fraction of their funds, on average, to higher return types of investments such as stocks. The pitfall here is that stocks are not always priced to deliver high returns. Historically, the price/earnings ratio on the S&P 500 has averaged about 14. When the price/earnings ratio has approached 20, stocks have typically returned less than Treasury bills for as much as a decade or more.While it is not possible to avoid every downturn in the market, it is essential to defend capital when the Market Climate suggests a poor tradeoff of expected return to risk. …….Here’s why. Suppose that you earn 20% returns in three consecutive years. Clearly, your average annual return is 20%. But suppose that in the fourth year you lose 20%. The combined effect of lost value and lost time has a profound impact on your annualized return. If you do the math, you’ll find that for the overall 4 year period, the compound annual rate of return has dropped to just 8.43%.While risk-taking is essential to generate long-term returns, it is important to understand that market risk is typically rewarded much better in some Market Climates than in others.

Increasing the time horizon

The best way to increase the time horizon T over which you compound wealth is simply to start saving and investing as early and consistently as possible. Consider an investor earning a 10% long term rate of return. If the investor saves $2000 annually in a tax-deferred account (such as an IRA) for 10 years, and adds nothing for the next 20 years, the value of the portfolio at the end of 30 years will be $198,575. Although the investor committed a total of only $20,000, the account will have grown nearly tenfold.Now consider an investor who fails to start early. Suppose that the investor saves nothing during the first 10 years, and then attempts to make up for lost time by investing $2000 annually for each of the next 20 years. At the end of 30 years, the value of this portfolio will be just $114,550. The investor has committed a total of $40,000, twice as much as the first investor, but because the funds were not given as much time to compound, the investor retires with just over half as much wealth as the early bird. The higher the compound annual rate of return, or the greater the number of years to retirement, the more dramatic the effect that an early start will have on the ending wealth.

Some advice about saving

The key rule of saving is this. Don’t let your savings adjust to your spending needs. Let your spending adjust to your savings needs. It will help tremendously if you budget a certain amount of saving monthly, and make your investments first, as if you were paying a telephone bill. If you wait until all the bills are paid and all the spending is done, the result may be that you have nothing meaningful left to invest……..The best strategy to manage credit card debt is to minimize the number of cards you carry. But if you ever want to save, then start saving now. Make your monthly investments when you pay your other bills, and treat them as if they had a substantial late-payment penalty. The penalty for starting a savings program late really is enormous.

The bottom line

Financial security does not require extraordinary income or investment “home runs.” It requires, first and foremost, that you start saving and investing early, and add to your investments consistently.As for investment strategy, financial security requires avoiding large losses, particularly in environments that have been historically hostile to stocks. And it requires the willingness to take larger amounts of market risk in environments that have been historically friendly to stocks.