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Investing Wealth

Compounding and the Self-Funding Portfolio

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Albert Einstein
Aivazovsky Shipwreck, 1856, pencil and gouache on paper

Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.

You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.

This is the power of compounding

Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.

When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.

In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.

However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.

It isn’t until these later stages that you truly start to see the benefits of compounding.

The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.

However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.

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Investing

Jeff Gundlach on the Next Economic Collapse

Jeff Gundlach, CEO of DoubleLine Capital predicted the election of Donald Trump and the 2007 housing crash. He is now providing insights into the next economic collapse.

Headshot of Jeff Gundlach

In 2011, he was featured as “The King of Bonds” in Barron’s, and named one of “5 Mutual Fund All-Stars” by Fortune Magazine. In 2012, he was named one of the “50 Most Influential” by Bloomberg Markets magazine. In 2013, he was named “Money Manager of the Year” by Institutional Investor.

When Jeff Gundlach speaks, people listen. Unlike most investment managers, he doesn’t hold back and is willing to tell it like he sees it. Listening to Gundlach is like getting a bucket of cold harsh reality poured on your head.

He was recently interviewed by a Swiss newspaper on what the next recession might look like. Gundlach warns investors to prepare because it will lead to big changes in the market. He argues investors need to reduce risk and own their house free and clear. (in fact, he says anyone with a mortgage should not own stocks.) While there might still be market gains over the near term, when the downturn does come people will be “overwhelmed by problems” with their investments. In particular, he sees big problems with the US corporate bond market.

“This time the liquidity is going to be very challenging in the corporate bond market. The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession. Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.”

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Gundlach also sees major problems with the US stock market, arguing it will be the worst performing equity market in the world. Why? Partly because it is currently the strongest.

“The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking. This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.”

The next recession will see deficit spending balloon. The US is already running $trillion+ deficits and this is supposed to be the best economy ever. The next recession could put upward pressure on interest rates, as demand for funding rises. Of course, the Fed will do everything in its power to combat this, but possibly not until after a crisis emerges. The firefighters don’t show up until the house is ablaze.

“Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference. He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US. You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.”

So what happens post recession when US public debt levels skyrocket due to massive deficit spending? Suddenly, the problem everyone has ignored could smack the US right in the face, and the US government will look for solutions.

You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest. …the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.”

Gundlach is not talking about a garden variety recession. This situation – massive debts, slowing growth, rising wealth inequality – has been building for decades and the world is approaching a point at which seismic shifts will occur.

This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.”

So what does normal look like?

In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened. In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.

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Wealth

How a High School Student Can Create $1 Million in Wealth

In this article I will explore how a teenager can set themselves up for retirement before even graduating high school. Indeed, it is possible to build over $1 million in future wealth before starting college.

Methodology

Most teenage students can manage part time work during the school year and full time work during the summers. With few expenses, the teen is able to invest every dollar earned. Of course, not all students will fit this profile. Some won’t find work. Others will be required to help with family expenses. But I think – with enough discipline  – many students can make this a reality.

I believe that the more hours you work at a part time job while in school the worse your academic performance. Therefore, I will keep weekly working hours during the school year at a very manageable level.

After all, this whole exercise is about setting up a successful future. That includes future earnings, which is dependent on a good education. So this experiment should not come at the expense of future earnings.

Also Read: Is Your Scarcity Mindset Holding You Back?

Assumptions:

  • Let’s assume that during the school year the student works one 8hr shift per week. 
  • School year is 40 weeks
  • During the summer, let’s assume the student works a 40hr week.
  • Summer is 8 weeks
  • Starts working in grade 9 through to grade 12
  • Earns $15/hr ($1 above minimum wage in Ontario, Canada)
  • No taxes or transaction costs

Based on these assumptions, the student would earn $9,600 each year (see table below) for four years.

But how does he turn this into $1 million by retirement?

Observations

If the student invests the $9,600 at the end of each of the four years and does nothing else, he could have over $1 million by age 65. The chart below illustrates how the investments would grow assuming average annualized returns of 5, 6 or 7%. (These are conservative estimates given long term historical returns are close to 10%.)

Of course, $1 million in the future will be worth less than $1 million today due to inflation. The chart below adjusts the investment returns to account for an annual inflation rate of 2%. Still, the student’s initial investment ($9,600 × 4) is worth between an estimated $166-430k by age 65 in today’s dollars.

That is more than most 40 year olds currently have saved for retirement. Can you imagine what this might look like if the student kept investing throughout his life?

The message here is simple. Start investing as young as possible and let the power of compounding grow your wealth.

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Investing

The S&P 500: Biased and Misleading

You’ve seen headlines like these:

“S&P 500 crashes today”

” The S&P 500 rose as earnings optimism rises”

“Record year for stocks, as S&P 500 up double-digits”

…and so on.

The problem with these statements is that they’re using the S&P 500 as a proxy for the overall market. I’ll be the first to admit that no index completely represents the market at all times. But in this article, I’ll point out some of the issues with the S&P 500.

The S&P 500 index is a market-capitalization weighted index made up of 500 of the largest publicly-traded companies in the United States. The stocks within the index represent a significant portion of value of all companies in America.

I am a big fan of low cost index investing. So why am I shit-talking the S&P 500?

Three reasons:

First, the index is arguably actively managed. All indices have a pre-programmed set of rules to determine its constituents, weightings and rebalancing frequency. An index and its characteristics need to be defined – like everything else in life – and that definition is the creation of a human being (or team of humans) making some sort of decisions. The activity undertaken to create these rules (and the activity in executing these rules) means that indices (like the S&P 500 index) may not be as passive as investors believe. While an investor can make a passive allocation to an index, that investor must first understand and believe in how that index is constructed.

Second, the index is highly concentrated. The chart at the beginning of this articles shows that the largest 5 stocks of the S&P 500 accounts for the same market cap as the last 279 companies of the index. These five companies are Microsoft, Amazon, Apple, Alphabet and Facebook. While these companies may seem like behemoths that could survive anything – thus deserving their big weights in the index – one only has to go back as far as 2010 to see a completely different composition. In 2010, the largest five stocks in the S&P 500 included Exxon, GE and Berkshire Hathaway. Where are they now? This degree of concentration presents a risk to investors, as the success of index constituents waxes and wanes. Essentially, the performance of the S&P 500 is dependent on the success or failure of just 5 companies.

Third, the index is effectively a buy-high sell-low strategy. Put simply, to get added to the index a company needs to be meaningfully large. Companies aren’t born large, so by the time they are big enough to be added to the S&P 500 they have often experienced years of growth. In other words, companies are added to the index AFTER they have performed well and potentially already trading at elevated levels. In contrast, a company is removed from the index if it falls from grace and has shrunk considerably (or even gone bankrupt) due to years of weak performance. Ideally, investments should be bought BEFORE they perform well and sold BEFORE they start to underperform. The S&P 500 (and many other indices) does the opposite, and is effectively a buy-high sell-low strategy.

Takeaway: If you are looking for simple, diversified access to passive exposure to equities I would first look for indices that are well constructed. These well constructed indices may not be what you see in the newspaper headlines, and some are proprietary to mutual fund or ETF manufacturers. Look for investment products that provide ‘total market’ exposure while capping the weight of each underlying holding. Take a look at the top 10 holdings of whatever index ETF or fund you are researching to ensure they represent no more than 25% of the overall assets. Finally, also consider an index ETF or fund that includes small, mid and large cap stocks to provide exposure to all phases of company growth (i.e. not simply to companies that have already gotten big).