Have you ever wanted to simply have a lot of money, like a billion dollars, so that you can go on a perpetual world tour, eating what you like, wearing what you want, driving what most others cannot afford and living in houses where no one else can? Well, I cannot promise you all of that, but what I have for you today is the single most effective wealth creation technique that will definitely push you in the direction, helping you to create millions and even hundreds of millions of dollars.
Let me start by clarifying first that this is not a get rich quick rich scheme and it takes time, effort and discipline to make and grow wealth. I am not going to claim that I can help you make a fortune overnight. There is no magic formula and you will have to work hard for it.
With that out of the way, let’s start with wealth or monetary wealth to be more specific. Wealth creation is a daunting task. However, it becomes much easier if you know how money works. The strategy I am going to discuss is taken from the practices of the Oracle of Omaha, Warren Buffet’s himself, of which he is a great vocal advocate as well. It is focused on two basic concepts: the power of compounding and dollar cost averaging. Below, I shall explain these two fundamental concepts before proceeding to the actual strategy.
The Power of Compounding
If you have ever taken out a bad loan, with a high-interest rate for a long-term period, you would have noticed how you end up paying off much more than what you originally borrowed. The same goes for a mortgage or a car loan. You buy a house on sale for $330,000. You pay 20% as a down payment and lease the rest of the $264,000 for 30 years. At an interest rate of merely 4% p.a. you get a monthly installment for $1,260 towards the principal and the interest, making a total of $453,600. That is a whopping 72% total interest on the principal amount. This is the power of compounding.
The good news is that you can use this principle to your advantage as well. Where the interest on long-term loans that you take out has the potential to cost you monumental amounts of interest, if you are on the other side of the table, you can easily use that to increase your money and it is one of the most effective wealth creation technique. Let’s take a look at the same example, but with a little change. Imagine that you managed to save the same amount of $264,000. If you invest that amount into a fund with a 4% interest rate compounded every year, your investment will be worth $853,257 in 30 years given that you do not make any withdrawals. This is more than 3 times the original amount. If we adjust the rate to 10%, which is almost the return you can get from a diversified portfolio or a US index fund, the amount shoots up to $4.6 million.
The difference between the first and the second example is that the amount is that in the first example, our aims are to deplete the original amount and in the second example, we are not touching the original amount and letting it compound. This small change lets the return grow from 72% in the first example to 224% in the second example. However, the lesson here is how the compounding effect works to increase the value of an asset, or a liability, over long periods of time.
Dollar-cost averaging is an investment technique used for minimizing the negative effect of market volatility from the buy-side of the investment. The main assumption behind this technique is that the market is always trying to find the perfect price of stock hence it keeps changing. Therefore, it is practically impossible to accurately predict the stock prices in the near future due to the high level of volatility in the market. However, it is possible to get very close to the average price of a stock by taking its mean over a period of time.
To incorporate this concept into practice, the dollar cost averaging technique suggests a unique investment method. Instead of buying the whole position in one go, the technique suggests breaking up the total investment amount into smaller, equal portions and buying at set intervals. This means that a fixed amount is invested into the portfolio at a fixed interval. This ends up removing the element of market volatility as well as many decision biases and you actually end up buying at the average price of the stock. Let’s illustrate this with a simple example.
Imagine that you have $10,000 to invest and you have decided to invest it all in Apple stock. Now, you have two options on how to proceed. The first option is that you time the market perfectly, and predict accurately when the price will be the lowest and buy at that price. However, as we have discussed above, it is impossible to accurately predict the price of a stock in the near future. The second option is to break up that $10,000 into smaller amounts of say $2,000 and buy every week on Wednesday at 3 pm at the market price for the next 5 weeks. Now, let’s suppose that the average share price came out to be $100 with a fluctuation of 5%. This means that if you went with the second option, when the price was $105 the same $2,000 got you 19 shares and when the price was at its low of $95, the same amount got you 21 shares. This way you ended up buying more shares when the price was low and less when the price was high, buying at an average price of $100.
For long-term investment, this strategy makes sense that’s why it is an effective wealth creation technique. When looking at a longer time period, the current market volatility has little to no impact on the decision on what to buy and what to sell. It is more focused on the long-term prospects of the business and the attractiveness of the environment that the business operates in. Eliminating the risk of buying at a slightly higher price makes sense in such strategies where the focus is not to profit from the smaller fluctuations in price.
The Dividend Snowball
Now that we are comfortable with the basic principles behind it, let’s dive into what this technique is. As I mentioned above, it is taken from the investment style of one of the world’s richest man Warren Buffet himself. He is an advocate of making safe bets on strong companies and let the time do your working. The name of the technique, The Dividend Snowball, revolves around making informed investments of small amounts in strong companies at regular intervals in a dividend reinvestment portfolio for long periods of time without withdrawing anything from it.
We can divide this strategy into two parts. The first part is the investment part while the second holding and reinvestment part. The model works like this:
- Whether you have lots of money or only a little, estimate a fixed amount that you can inject into a fund every month that you will use to buy stocks. Do not try to save up huge amounts first. Buying monthly will give you the advantage of dollar-cost averaging.
- Identify companies with a high dividend yield that you think will be doing well in the next 30 to 50 years. These need to be strong companies whose share you can comfortably hold for a long period of time. If you are not sure, index funds are usually a safe bet.
- Once every month, buy the stocks in your selected companies with the fixed amount that you decided on in step 1.
- Every time you get a dividend, reinvest that dividend into your portfolio, buying the stock of the same or a different, more attractive company.
- Let all of this compound for 20 to 30 years as you see your wealth grow.
As I mentioned earlier, it is not a get rich quick scheme, but the most effective wealth creation technique and one of the least risky approach to building wealth. Let’s illustrate this with an example.
Suppose that you decide to invest $1,000 every month into the S&P 500 index fund. This has a historic average rate of return of 8% for the past 90+ years. This return is further divided into the dividend and capital gains, but for the purpose of this example, we shall apply the overall blanket rate of 8% to our portfolio. The table below shows the amount invested into the fund every year, the total fund value at the start of each year and the return you will earn every year at the end of the year on your portfolio. You will notice how at the start, the figures start small, with the first-year return of only $960 but as the portfolio keeps growing, the returns keep growing exponentially. According to the projection, by the 10th year, you will be getting more in return than the $1000 monthly you are investing and by the end of 30th year, your portfolio is a little more than a year shy of being $1.5 million, with an annual return of $108,000 which is almost ten times the annual amount that you put into the fund.
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So, what’s the catch?
Sounds too good to be true? It should not. However, there are a few things that need to be considered before getting too excited about the wealth creation technique. While this technique provides a mathematical guarantee for wealth creation, there are things outside the scope of this technique that may negatively influence the outcomes making things less than ideal.
The first thing to consider is that the technique assumes that you have spare cash to invest every month and then focuses on investing that amount into the stocks. However, not everyone fulfills this requirement. If you cannot comfortably spare a reasonable amount every month, you will need to focus more on increasing your income, reducing your expenses or both.
The second most important thing to understand is that investment has its risks. Although in the long run, share prices tend to rise, there may be years of profits followed by years of losses. If you are easily shaken by the possibility of losing a significant amount of your portfolio, the stock market may not be the thing for you. However, investing for long time periods as in the examples above tends to be less prone to losses. If you cannot make an educated estimate about the future of companies, diversification further reduces the risks.
The last thing I would like to mention here for an effective wealth creation technique is that the risk appetite and other personal circumstances of individuals vary greatly. You reading this article does not allow me to judge your situation. Do not take this as direct financial advice. Learn more about money and investing. Educate yourself on the pros and cons of everything before you take an action. I always recommend my readers to consult a financial advisor to tailor the available strategies to your personal circumstances for the best possible results.