Returns and Compounding - A Simple Viewpoint

Discussion in 'Financial Planning' started by kierank, 16th Jan, 2020 at 7:07 PM.

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  1. kierank

    kierank Well-Known Member

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    Today, I was asked by a (younger) cousin to help them out with their Net Worth journey.

    They are fairly conservative by nature. Their Super has been producing yields of around 6% to 7% pa and I was insisting they should be getting 9%+. They were of the opinion that the 2% to 3% variance wouldn't make that much difference in the long-term.

    They were asking me why I am so adamant about Investment Returns and Compounding. It started out as a phone call; then I backed it up with an email.

    I thought I would share part of that email on PC as it might help other newbies. Here it is:

    "Returns and compounding are the name of the game. I assume you are aware of the Rule of 72. This rule means that:
    1. If one’s investments are Aggressive (say, 12% pa return), then one is aiming to double the value of their investment every 6 years (that is, 72 / 12%).

    2. If one’s investments are Balanced (say, 9% pa return), then one is aiming to double the value of their investment every 8 years (that is, 72 / 9%).

    3. If one’s investments are Conservative (say, 6% pa return), then one is aiming to double the value of their investment every 12 years (that is, 72 / 6%).

    4. If one’s investments are in Cash (say, 2% pa return), then one is aiming to double the value of their investment every 36 years (that is, 72 / 2%).
    Note:- these returns are before tax and before withdrawals.

    The lessons from the above:- Cash Only is risky (to Net Worth creation). Also, the above shows that it takes 50% more time for a Conservative Investment to reach the same destination as a Balanced Investment AND double the time as an Aggressive Investment.

    Therefore, Conservative Investment can be considered risky as well, especially if one is still reasonably young. I am not a big fan of Aggressive investments due to the risk of losing capital.

    In summary, I prefer Balanced investments or higher and, as one ages, one should lower the risk (and the return). I don’t know whether I will ever get as low as Conservative.

    If one looks at our Asset Split, one can see that we have a lot of growth assets (88%).

    Even if one looks at our Net Worth Split (assets – debt), one can see that we still have a lot of growth assets (83%)."​

    That simple explanation really hit home for them and gave them a few things to think about. I hope it might make some sense to others.

    PS
    I selected returns like 12%, 9%, 6% etc to prove a point (and they were easily divisible into 72 :)).

    Obviously, one can plug in one's own numbers to prove a similar point.
     
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  2. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    With declining yields your well intentioned but possibly unqualified advice is that they must chase high risk for maintaining yield. To increase yield means adopting ever increasing higher risk. And a 9-12% that may be significant. This is the risk v reward trade off.

    Growth calcs also must factor in expected adverse movements. The higher the yield the more likely a adverse impact event will revert the return. ASIC describes it here. And then...

    For a 40% loss it requires a future 66.66% growth to merely restore the original capital. The main ASX index took 10 years to recover from the GFC impacts. I will always argue that if someone cant forsee a 40% fall they cant forsee the next growth surge. Obviously some listings under performed (or went bust) and others out performed.
     
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  3. Trainee

    Trainee Well-Known Member

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    When it comes to property though the calc is very different. Is a property riskier because there is a mortgage?
     
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  4. spludgey

    spludgey Well-Known Member

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    I agree with you.
    Simplified table here. I did it for an annual contribution of $6k (after fees). Not accurate, but good enough to get some sort of feel for it.

    upload_2020-1-17_11-38-58.png

    Also, I'm not that big a fan of the 72 method, as it doesn't work well at the extremes.
     
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  5. kierank

    kierank Well-Known Member

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    In my OP, I was referring to cash contributions to keep it simple but one could take out a loan to buy shares if one wants to increase the risk (and potential reward).
     
  6. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    A mortgage is just loan security. It is only a issue where the income ceases and the fund lacks capacity to meet its obligations. Then the fund will have other choices

    1. Rollover ?
    2. New members ?
    3. Redirect contributions as new stream of cash ?
    4. Director guarantee (bank will decide that)
    5. Sale of property by owner or lender
    Refinance isnt generally a option if lack of liquidity + default approaches.

    Property and shares are both passive investment. Unlike shares which can be exchange traded property comes with slower outcomes, costs of selling and in some cases buyers may dictate price when demand is low. A poorly presented property may also suffer in value if the vendor cant afford to present it well due to cashflow eg repairs are needed.

    Market v's specific asset risk is also a consideration.
     
  7. kierank

    kierank Well-Known Member

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    As I stated in my OP, I only posted part of my email on PC. I did close off my email with the following:
    "The above are my thoughts/opinion and is NOT advice (as I am not qualified/certified to give financial advice)."​

    I was more focussed on Total Returns (growth + yield) for investments, not yield per se. In the introductory part of the email (which I didn't post on PC), I did state:
    "This highlights that Aggressive investing over time should yield higher returns and Conservative investing lower returns. This is the Risk/Reward ratio."​

    My email was aim at educating them in investment concepts, not advice on any particular investment or strategy. Maybe, I might have been better to include more of the email but I thought that would make the OP too long. I do appreciate everyone's feedback.

    Unfortunately, their current (qualified) financial planner has them invested in up to 50% cash (for the 18 last years). They are disappointed with the returns they are getting and they see it having a huge impact on their retirement options (unless they take corrective action). My email was aimed at addressing their lack of knowledge in this area.
     
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  8. oracle

    oracle Well-Known Member

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    The law as it stands only allows people with financial planning degree to give financial advise. Whether that advise works for the client in the long run is irrelevant. People who have experience and runs on the board are normally looked down by the financial planning industry as being unqualified and against the law.

    The irony is when it comes to finance and investing this is the only industry where a completely uneducated and/or no finance/investing interest person can vastly outperform someone with a Phd qualification in finance. They only need to do few simple things right. In no other industry you would see this happen.

    Cheers
    Oracle
     
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  9. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    Thats not presently the law. There is a process for those without degrees to move to that or exit the industry. A degree doesnt mean the advice will improve if the industry still does the wrong thing. It may take some time to lift practices. The FASEA exams etc will help a bit. A lot are about to get a rude shock when they fail.

    Its like tax. Having a degree doesnt mean jack. You can have a accounting and business degree and no skills, language skills, experience. That said the TPG keep the riff raf out by applying tight rules to allow people to practice and then register in tax. But not while they are a employee ! They just must be supervised.