Free lunch that can be taken to bank

Three personal finance principles help savers to build strong net worth

KARACHI:

You might have heard “there’s no free lunch in business”. But when it comes to investing, there is an exception to that rule.

Three principles are like free lunch – they don’t cost you anything – and are always available to aid any saver seeking to build a net worth. These principles are power of compounding, diversification and dollar cost averaging.

Power of compounding

So, what is a reasonable return for you? Let’s start with the Rule of 72, but view it a little differently.

Most people divide 72 by the return they are being offered to determine how many years would it take for them to double their principal.

You may also use the Rule of 72 to divide 72 by the number of years in which you wish to double your money to arrive at your targeted annual returns.

So, let’s say you are willing to wait eight years to double your money. Seventy two divided by 8 gives you 9 – so you would need a 9% average return over the next eight years to double your money. And you then look for investments that deliver those targeted returns.

Let’s say you are 33 and intend to retire at 65, so there are 32 years left in your career and you have saved up $100,000 so far.

According to the Rule of 72, even if you don’t add another penny to your savings, you’ll retire a millionaire if you keep earning 9% on your savings and keep reinvesting those returns back each year.

Your $100,000 will double to $200,000 by the time you are 41 years old, $400,000 by the time you are 49, $800,000 by the time you are 57, and double again to approximately $1.6 million at 65 years of age.

Read more: Investment doesn’t come easy

The power of exponential growth through compounding is the most powerful secret of finance. It’s a mathematical reality that is available to everyone – and been available throughout ages. Just something that escapes the untrained eyes and is latched on to by the more astute.

Diversification

How do you set up your portfolio to achieve the desired returns, yet keep yourself protected from volatility?

On May 1, 2021, the billionaire investor – Warren Buffett – celebrated being an active investor for 70 years, with a net worth of $80 billion. He opened the annual meeting of his company – Berkshire Hathaway – by saying to new investors that there is a “great argument for index funds.”

Similarly, consider diversifying securities between fixed income and equities, and then diversifying bonds across public bonds and private bonds depending on your risk profile.

And the same for stocks – pick a selection of mutual funds across domestic and overseas. You may also diversify your savings by owning real estate – such as owning your home or a rental property. And lastly, recognise where your income originates.

If you work in technology or healthcare, then lighten up those stock sectors in your investment portfolio to protect from an industry shock jeopardising your livelihood and your nest egg at the same time.

Dollar cost averaging

Over the long term, dollar cost averaging your way into the market is a better way to invest than attempting to time it. That way you bring your funds in during good times and bad, buying securities when undervalued and even in times when overvalued.

Since there is no way to predict for certain whether the next move will be up or down, you are better off staying the course by investing a steady dollar amount each month in the market.

Time and again, stock markets become a bit of a roller coaster ride. But rest assured, over the long run they generate solid returns.

So, in the short term, you need the resolve to ride through the volatility. So, better to set up your portfolio selections and investing schedule in a way that you wouldn’t be perturbed by up to 20% drop – and you’d find it easier to withstand the turbulence by sticking through such tough times by staying the course of always averaging yourself into the market.

Find a sounding board

Determining your investment allocation across stocks, bonds or real estate can be a lonely exercise, leading sometimes to emotional decisions when dispassionate assessment is required.

To keep decisions clinical, find a trustworthy individual to discuss your financial strategies with who could act as a sounding board. That could be your financial adviser, a friend, a business partner, your spouse, a sibling, or members of an online investment group. If you prefer to keep numbers confidential, simply discuss your strategies in illustrations and percentages, so you get to test your hypothesis with others as well.

The most compelling reason for having a sounding board is to not let your emotions get the better of you when making investment decisions.

The writer is a technology marketing leader with more than 20 years of experience at Fortune 500 companies. He has written extensively on economics and technology, and has co-authored two books

 

Published in The Express Tribune, June 7^th, 2021.

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