Build wealth using the power of compounding, not trading

WHO the hell would want to be an investor? On Thursday, the ups became downs, and "gains for 2013 evaporated".

Birthday cake

WHO the hell would want to be an investor? On Thursday, the ups became downs, and "gains for 2013 evaporated", according to the front pages of various business newspapers.

This, of course, wasn't true, but let's not let the truth get in the way of a catchy headline.

What does matter is that to the average person with their life savings on the line, it reinforced the sobering belief that investing is akin to gambling.

But gains have only evaporated if you're a trader - if you're an investor, you're still up.

The Japanese market went down 6 per cent on Thursday.

Despite yesterday's rally, our market is approaching an official correction, down more than 8 per cent from last month's high. Of course the term correction sounds like something a grade 3 teacher did to your homework and nothing to do with losing cold hard cash, but then hey, that's finance guys for you.

Wealthy investors, those who go on to multiply their wealth over and over, don't pay a lot of attention to the share price - in the short term at least.

Instead, they focus on what Albert Einstein called the eighth wonder of the world - compounding - and specifically on how they can turbocharge their efforts to reach their goals. Let me explain

Where do the returns really come from?

Good companies earn profits. Great ones retain and reinvest some of those profits back into the business, then, twice a year, share what's left over (the dividend) with their investors.

Research from the prestigious Wharton School at the University of Pennsylvania shows 70 per cent of an investor's return comes from the dividends they receive in the mail - not the share price increasing.

And if you choose to reinvest the dividends you receive into buying more shares, your investment grows - because the dividends also start making money. And with time, your investment takes on the appearance of a snowball rolling down a hill - getting bigger and bigger.

How to double your money in 46 years

Professor Jeremy Siegel from the university looked at the returns of share prices, adjusted them for inflation, and found they only went up by about 1.5 per cent a year.

With investing, you should always look at the "real" numbers, that is, with inflation (rising prices) factored in.

That way, whatever your investment grows to, your purchasing power per dollar is the same as it is today.

In other words, the average punter makes only 1.5 per cent a year in share price gains (and that's before we take into account fees and taxes). At that rate you'll double your money (in today's dollars) in 46 years.

How to double your money in 10 years

Now let's see what the wealthy do. Remember all those dividend cheques in the mail? They don't spend them. They use them to buy more shares. How?

Well, some companies make the reinvestment of dividends really easy. They offer shareholders the option to sign up to a Dividend Reinvestment Plan. Not every company does this, but most of the bigger companies do (such as Woolworths, the banks and the Australian Foundation Investment Company)

When a dividend payment falls due, their DRP will issue you with extra shares rather than cash. This not only saves on brokerage fees for you, but as an added benefit, they'll usually offer the new shares at a slight discount to the share market price. Double bonus.

So, using Prof Siegel's figures, these dividends add another 5.5 per cent to the returns, making a total of about 7 per cent per year (this is being conservative). With these returns, your investment now doubles in 10 years, not 46.

And in the time the average punter has doubled their money (say, turning $10,000 into $20,000 over 46 years), yours will have increased 20-fold (turning $10,000 into $200,000).

Compound your compounding

The investments that Prof Siegel studied used an average bunch of companies. Which is easily replicated by buying a Listed Investment Company such as AFIC and hanging on for the long haul.

But what if you own better-than-average companies?

If you can find wonderfully profitable companies such as Woolworths, you'll in effect be compounding your compounding. Even if they only squeeze out an extra 1 per cent annual return, your initial investment will go up 35-fold (turning $10,000 into $350,000).

Treading Barefoot

The most reliable way to create wealth is to build it over time, by buying shares in good companies and using the power of compounding. Not trading.

And if you find great companies, you'll be well on your way to not only becoming a successful investor, but an incredibly wealthy one.

Just remember not to get too carried away by the headlines - or the share price fluctuations.

Tread Your Own Path!

Contact Scott Pape at barefootinvestor.com or [e-mail]