Investment Moats

Of Having More Conviction, Rolling Returns and Dimensional Core Equity

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When we put our money in fixed deposits or savings account, we can reliably count on that if we put the money in on May 2018 and take it out in May 2020, we will get a certain annualized and cumulative returns.

It is difficult for a person new to investing to visualize their returns when the asset’s value or return is volatile. If you invest in individual stocks, unit trust, or ILPs, the value of your investments change over time.

With this kind of uncertainty, it is no wonder wealth builders stuck to tried and tested forms of investment.

I tried to think back to what convinced me to put my money in the stock markets instead of fixed deposit last time. At the start, I was not particularly convinced when the books showed that if you keep your money from 1929 to 2001, your wealth will compound at a 7-10% a year rate of return.

The time frame was too long and I read that the markets are always known to be uncertain and volatile.

I don’t think I would invest for 70 years. How would it fare in a shorter, but long time frame?

What if I was unlucky to put a huge chunk of my money in a time frame that was unfavorable? Would I regret my decision to take risk instead of putting my money in something else?

I viewed the markets with skepticism even as I was learning to be an individual stock investor.

What greatly convinced me was to look at the historical returns of various past long term periods. These periods are long but not super long. They are more practical and applicable because as new investors, we need to see some results in order to be convinced.

I think 5,7 and 10 years are a good time frame to judge.

An example of a series of rolling returns

The table above was taken from a Providend article I have written this week on Rolling Returns, Conviction and Dimensional Core Equity Fund.

It shows 5 different rolling 10-year periods and they’re corresponding annualized and cumulative returns. We observe that the returns are not fixed. In some 10-year periods, the return can be very good (1991-2000) but most are close to the average.

By reviewing the rolling returns, we gain an appreciation of the range of returns we could get if we are lucky, not lucky, or when our luck is pretty even.

The article goes into more data but I would just like to highlight what is likely to happen as you lived through a 20-year investing period.

1-year Returns

The histogram above shows the 1-year return of the Dimensional Core Equity Index from 1990 to 2019. This is a fund that tries to outperform the MSCI World index, so it is rather developed market-focused, very diversified (7000+ stocks), tilted towards value, higher profitability and smaller companies.

Each bar shows a range of returns. For example, there are 53 instances where the returns are between -0.2% to 7.7%.

In this 29 years time frame, if we break them up into months, there are 348 1-year periods. The range of returns varies wildly. The median returns is 11.5% a year. But there are some years where the returns can be negative.

5-year rolling returns

If we stick with the portfolio for 5 years, you will observe the cumulative returns tends to skew towards more positive.

There are still some 5-year periods where your returns are negative. The worse will be that you invest $100,000 and 5 years later it ends up $80,000.

That is not a good feeling.

But you could also have $100,000 becoming $261,000 in 5 years.

20-Year Annualized and Cumulative Returns

If you managed to stick in the fund for 20 years, you can see the range of returns above. Based on this 29-year history, there are 130 20-year periods.

The most unlucky investor got only 4.2% a year annualized return after 20 years. His $100,000 grew to $221,000 in 20 years.

The investor in the middle grew his money to $419,000.

Investing in equities can be uncertain. It depends sometimes on your luck, but it tends to be positively skewed.

For the young accumulator, you can look at this in a different way: Each $12,000 that you put in each year goes through 1 of these 20-year periods. Some of your $12,000 grow at only 4.2% a year. Some $12,000 grow at 8.2% a year.

The volatility of your returns are smoothed over time.

There are data on more different time frames in the article.

Do let me know if this kind of narrative helps you as a new investor or you have other suggestions about what convinced you to put a large chunk of your net worth into something.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for first meeting to understand how it works

A Strategy to Avoid The Pain of Losses? Don’t Be Naive

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When Eagle Hospitality Trust’s (EHT) share price fell recently, I thought it is a rather good exercise to take a look at how 5 investors will experience the downside.

EHT is a real estate investment trust (REIT) who master leased their assets to their sponsors.

At various price points, it provides the investor with a dividend yield of 8% to 14%, based on their forecasted cash flow guidelines.

When the share price fell, many investors sell. There are also investors who think there is a value somewhere and are buying.

This is, after all, a business model that is not very unfamiliar to many people. It looks like it is fixable in the long term. At the same time, there is uncertainty because it feels like the current true value of the hotels are much less than what was stated in the IPO.

The Experiences of 5 Investors

Suppose we have 5 investors that tried and successfully gotten invested in EHT at different times.

All 5 investors have the same mentality:

  1. They think that at the price they buy, there is value. While the time period they are looking at is different, they believe that given the time frame they are looking at, the total return (dividend income received + capital appreciation) will outweigh the prices they are paying now.
  2. They all don’t like to lose money. The feeling of seeing their capital in the red kills them.
  3. If given the choice they want to protect their downside
  4. They all want to get in at the price where it is the lowest

So the price chart of EHT for the past 3 months plus look like this:

The price could go three ways:

  1. Up
  2. Down
  3. Sideways

Depend on the timeframe.

Which Investors Feel the Least Pain?

When we

  1. Sell and buy back at a lower price
  2. Wait to buy at a lower price
  3. Take profit and then try to buy back lower (almost similar to #1)
  4. Buy only after a certain plunge

Behavioral wise, we are trying to minimize the pain.

So how did this work out for our investors?

The table shows our 5 investors, who sought to buy at the closest value point, where they will be able to maximize their profits, minimize their downside:

The percentage of losses at different price points

Suppose time suspended today and we take stock of the performance.

At this point, investors 1 to 4 all have unrealized losses:

  • Investor 1 lost 35.4%
  • Investor 2 lost 31.6%
  • Investor 3 lost 29%
  • Investor 4 lost 17%

Investor 5 has the best timing and managed to get out a 5.7% return.

Who was the Smart One?

Investor 3 thought he got a good deal.

Looking at the price chart, he got in at $0.655 instead of the high of $0.68.

Investor 2 would argue she got a good deal. Instead of getting it close to IPO at $0.72 she got it at $0.68.

If we were to use some hindsight bias, and we review this way, Investor 4 got the best deal out of those that currently lost money. She got in at not $0.72, not $0.68, not $0.655 but a much, much lower $0.56.

At this point, the smartest is, of course, Investor 5 who managed to end up with a profit.

In the end, the 3 investors after the first one didn’t avoid downside. They still suffered losses.

The Impact may be Different If We Consider the Potential Absolute Losses

What spook most of us with losses is that:

  1. We think we are making the biggest mistake of our lives
  2. We think we are losing a large part of our net worth and that is irrecoverable

In terms of percentage, the impact might not be as big. But what if we present it in terms of absolute dollars?

Imagine that Investor 1 to 5 invested $100,000.

Investors 1 to 3 have potential losses of nearly $30,000 while Investor 4 has potential losses of $17,000.

To some of you losing $30,000 is a very, very, very big deal and something very distressing. For some of you, this is nothing much.

What if We Layer in Net Worth and Time Horizon?

Suppose I tell you that Investor 1’s net worth is $2 million.

Do you think if you are Investor 1, you can endure an unrealized loss of $-35,417?

I think Investor 1 had an easier time than Investor 3 if we know Investor 3’s net worth is $120,000. With a $-29,000 loss, she almost lost 24% of her net worth.

But Investor 3 will feel less pain if we know that her salary is $80,000 a year and she has 20 years more to retirement.

While this potential loss is large if she can critically think, her savings from her salary over the next 20 years will more than offset this $29,000 of potential loss.

You Need to Learn to Live with Psychological Stress of Being in the Market

We all wish to avoid feeling the pain of seeing our hard earn and previous money vanish in thin air.

But if we use price as the sole indicator in our investment decision making, you might not avoid that painful feeling of seeing your portfolio in a losing position.

In this EHT example, 4 out of the 5 investors suffered the psychological stress of seeing their portfolio in a big losing position.

There is this strategy being passed around that you should only invest in a great bear market. One where the market went down at least 30%.

It is likely they wish to

  1. avoid losing money
  2. looking like a vegetable head
  3. suffering losses to their psychological capital

The math of things tell me that you can’t avoid the pain of seeing large unrealized losses in your portfolio.

You cannot avoid the pain:

  1. For those picking the bottom, only a handful would manage to do that. And they do so by luck most of the time
  2. For those buying at the bottom, if you see a stock go down from $1.00 to $0.30 and you buy it, don’t feel surprise seeing it go down to $0.15. You avoid a 70% potential loss, only to get into a 50% potential loss.

What is the solution?

Based on what I understand being in the markets this 15 years, there is not much strategy that can make you avoid the pain and still earn a great return.

It means… you need to increase your willingness to take risk by learning to endure this psychological stress.

Long term, you are likely to earn good returns.

The cost is that you need to pay for this by enduring psychological stress.

This is Your Pact with the Devil.

Being a historian of the markets, being a connoisseur of understand behavioral finance can help you cope with the pain of unrealized losses better. It may enable you to retain as much psychological capital as possible.

Lastly, in financial planning, we talk about your ability to take risks. Many pay lip service to it until they take psychological damage from the markets and see their psychological capital depleting at a much faster pace than their financial capital.

I have shown you that your position sizing, relative to your net worth, to your income and how far you are from your wealth accumulation goal, affects how much psychological damage that you may take.

If you are near your goal, your income is going to stop soon, your ability to take risk is much, much lower even though your willingness to take risk is high. If you lose a large part of your capital, it will be very hard to earn them back.

However, if you have a long time horizon, even though you have lost a significant part of your net worth this time around, you learn from this possible mistake. In the next 15 years, you would replenish your capital through savings and if the stock recovers.

Here is a summary of making pain more livable:

  1. Understand Your Investment Strategy – It has to be both Fundamentally Sound and Implementable/Applicable to You
  2. Not evaluate based on price but based on understanding the business and whether you have a margin of safety in your investment
  3. Understand your ability to take risk. This is dependent on your time horizon – how far are you from your wealth accumulation goal
  4. Size each position carefully based on
    1. Your Net Wealth
    2. Your Percentage Savings Rate of your Net Salary from Work
  5. Be a historian of the markets, being a connoisseur of understand behavioral finance can help you cope with the pain of unrealized losses better

If you like content like this, I write more of this in my Active Investing section below:

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for first meeting to understand how it works

2 New ETFs helping Singaporeans Gain Diversified Global Equity Exposures

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One of my ex-co-worker let me know that there are 2 exchange traded funds (ETF) listed on the London Stock Exchange this year.

I thought these are pretty good to let you guys and gals be aware of.

This is more suitable for the buy-and-hold investors who understand the benefits and shortcomings of investing in a low-cost portfolio by doing it yourself.

This is in contrast to purchasing through easier to access robo-advisers platform.

Both ETFs are UCITS ETF that are domiciled in Ireland and they are listed on the London Stock Exchange (LSE).

We prefer the ETF and unit trusts domiciled in Ireland because they are more optimized in terms of minimizing withholding taxes on the dividends received, and reducing estate duty/inheritance tax/death taxes complications should the investor passed away.

You can read my definitive guide to withholding tax when it comes to stock and passive investing to understand why you need to take note of this aspect when you are investing.

You can purchase these ETFs through the brokerage platforms that give you assess to the London Stock Exchange. Interactive Brokers is the cheapest, but not the most straightforward to use. Standard Chartered Online Trading, DBS Vickers are some of the other brokers that you can consider.

The SPDR MSCI World UCITS ETF (SWRD)

This new ETF by State Street was incepted on 28th Feb 2019. It tracks the MSCI World Total Return Index.

When you purchase the SWRD you gain exposure to 1643 developed market stocks around the world. You would own the largest companies and less of the smaller companies because the index is market capitalization-weighted.

The appeal of this ETF is that the annual expense ratio is very low at 0.12%.

After adding in the trading commissions, the cost of owning a basket of 1643 developed market stocks will probably be among the lowest.

State Street does have an existing world equity ETF listed on the London Stock Exchange in SPDR MSCI ACWI UCITS ETF (ACWD). ACWD tracks MSCI ACWI (all country world index) Index, which comprises more of developed and emerging markets.

SWRD is more focus on only the developed markets. Typically, when you add smaller stocks and emerging market stocks, the execution cost is higher. Thus, your annual expense ratio also goes up. You will see this later in the comparison.

This ETF is also accumulating, which means that when the underlying stocks pay out a dividend to the ETF, the ETF does not distribute to you. The ETF reinvest the dividends back into the fund.

The FTSE All-World UCITS ETF (USD) Accumulating (VWRA)

Vanguard listed this ETF on 23rd July 2019. This ETF tracks the FTSE All World Index, which measures the market performance of large and medium stocks of companies in the world.

VWRA includes emerging market stocks. Thus, it is more similar to the SPDR MSCI ACWI ETF than SWRD.

By owning VWRA over SWRD, you have exposure to more emerging market stocks. You would also take on more volatility due to the emerging market exposure.

The expense ratio of VWRA is 0.25%. For a mixture of developed markets and emerging markets, VWRA’s expense ratio is rather low. By comparison, SPDR MSCI ACWI ETF has an expense ratio of 0.40%.

This ETF is also accumulating, which means that when the underlying stocks pay out a dividend to the ETF, the ETF does not distribute to you. The ETF reinvest the dividends back into the fund.

Let Us Compare the ETF/Funds that Gives You World Exposure

comparing etfs that give Singaporeans global exposure - SPDR MSCI World UCITS ETF SWRD), iShares Core MSCI World UCITS ETF IWDA, Vanguard FTSE All-World UCITS ETF VWRA, DFA Global Core Equity Fund, SPDR MSCI ACWI UCITS ETF ACWD, SPDR MSCI World Small Cap UCITS ETF WDSC, DFA World Equity Fund, iShares Core MSCI EM IMI UCITS ETF EIMI
Comparing low-cost ETF and unit trust that give Singaporeans global exposure (click to view larger table)

The table above shows how VWRA and SWRD stack up against some of the existing ETFs and funds.

They are all listed on the London Stock Exchange (LSE)

I have included 2 Dimensional funds that give investors exposure to a global equity allocation for work purposes (just so I do not have to do it again, and that our advisers may read this post as well)

SWRD is in direct competition with BlackRock’s very popular IWDA. Like SWRD, IWDA tracks the MSCI World Index. Both IWDA and SWRD have the same amount of stocks.

They are both narrower than the rest on the table with 1650 stocks plus-minus. However, this is vastly more diversified if have only invested domestically.

SWRD’s 0.12% expense ratio is much lower than IWDA’s 0.20% expense ratio. However, we have to see how the tracking error is like.

What happens when you add Emerging Markets and Small Cap

As we add more emerging markets stocks and smaller capitalization stocks, what you will notice is that

  1. the number of holdings increases
  2. the expense ratio goes up
  3. the performance goes down

VWRA, Dimensional’s Global Core Equity Fund, World Equity Fund, and ACWD falls into this category of large-cap stocks + emerging markets or smaller capitalization stocks.

The 2 Dimensional funds expense ratio goes up to 0.35% and 0.43%. ACWD has almost the same expense ratio of 0.40%.

I have added one global small-cap ETF in SPDR MSCI World Small Cap UCITS ETF (WDSC) and one global emerging market ETF in iShares Core MSCI EM IMI UCITS ETF (EIMI).

When I saw that EIMI’s annual expense ratio is only 0.18%, I can’t help but feel impressed.

VWRA, the 2 Dimensional funds, EIMI, ACWD gives you exposure to more companies. These are likely to be smaller capitalization companies.

The Smaller Cap and Emerging Market Hurt Recent Performance

I have listed the year to date performance available at the last column. DFA World Equity is rather new for its USD class so I took the GBP performance and convert it to USD.

If you are invested in IWDA, you would have gained 17.37% this year to date (from 1 Jan to 30th Aug or 8 months).

DFA Global Core Equity clocks in at 13.41% and World Equity fund clocks in at 10.47%.

The MSCI World Small Cap ETF (WDSC) did rather well at 12.83% but the Emerging Market ETF returned only 3.30%.

DFA Global Core Equity did better than the World Equity fund by virtue of having no emerging markets (World Equity Fund has 12% in emerging markets)

Global Core Equity did worse than IWDA by virtue that is more weighted towards small-cap. That is why its performance is closer to the pure small-cap ETF (Global Core’s performance sits between IWDA and WDSC).

<< I removed an image that I may not be able to show >>

The matrix box above compares Global Core Equity fund’s allocation to small/medium/large companies and growth/neutral/value. Observe the larger weight to small and value.

Value and Small-cap has been relatively poor in performance for the past 7 to 8 years. If your bet is that the trend will continue, then you know which horse to pick. If your bet is otherwise, you will also know the horse to pick.

Conclusion

Personally I am really glad my ex-co-worker bring up this question with me. I am very happy that not just for Singaporeans, international investors have more great options to build wealth in a passive way.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

  1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
  2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
  3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
  4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
  5. Free Stock Portfolio Tracking Google Sheets that many love
  6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
  7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for first meeting to understand how it works

How to Get Rich (Realistically) and Stay Wealthy

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The majority of the rich who got really wealthy took calculated risks. They also had the foresight to see things that a lot of us would not be able to see.

Rich people surround themselves with people more competent then them in areas they are not good at.

Most of the time, the wealthy was also able to execute their plans very well. You will also find them having the ability listen to others when it is time to listen. But be steadfast when they needed to.

I got very little of these traits.

And maybe that is why I am not rich (by today’s much higher standards). I worked in a firm where we steward our client’s wealth carefully, so I know where I stand in the spectrum of people who are rich and poor.

But I do think that I have enough wealth for myself though. Enough for me to have a conversation with you on this topic.

The pertinent question on your mind is:

Absent of luck or being born into an affluent status, how do you realistically become rich?

There are a lot of posts out there trying to let you in on this secret.

But there is really no secret.

I read enough money stuff for the past 18 or so years. Having invested my money and built wealth through active stock investing for 15 of those years, I became financially independent and have also written enough stuff on financial independence as a subject.

Most of my friends in the blogosphere became very much richer than when they started years ago by doing roughly the same things as I did. Some of my friends not writing, but building businesses distill it as pretty close to something like this.

We learn from a lot of our firm’s clients that is how they build their wealth and sustain their wealth as well.

The idea to become wealthier than you are now is quite simple. It is just that the information is all over the place. The tactics comes in different flavors but usually around the same point.

So this post sought to help you piece everything together, and add some comments on how I did when it in the Wealthy Formula (I didn’t do well in all areas!)

The General Idea to be Realistically Wealthy is in this Formula

We tackle the money side of things first.

My Wealthy Formula - How Average People Achieve Wealth
The wealthy formula in a nutshell.

If there is one thing to remember, it is this diagram above. In your life, you will keep doing the things above over and over again.

1. You will increase the GAP or Personal Free Cash Flow

There is this gap between what you earn and what you spend.

We also call this the personal free cash flow. The bigger this gap, the greater your personal free cash flow.

Suppose after tax, I earn $60,000 a year.

My essential expense are the expenses that I need to survive adequately.

This will be

  1. my meals at home and outside
  2. meals for my family
  3. my transport
  4. phone utilities, home utilities
  5. home maintenance
  6. health insurance, taxes.

These essential expenses come up to $20,000 a year. So I have $40,000 a year left.

This is my free cash flow or GAP.

The greater your personal free cash flow, the more deliberate decisions you can make:

  1. Spend on entertainment, shopping and rich living. This may enhance your well being. Will not increase your net wealth
  2. Pay down your debt. This will increase your net wealth
  3. Capital to build wealth. This will increase your net wealth
  4. Go for training, courses, higher education. This will increase your future net wealth

You have the choice of spending it on your family, or on yourself or you could choose to delay spending to the future, and deploy your cash flow to build wealth assets now.

In order to build wealth your GAP needs to get larger and larger. Then you can put them in investments to earn a higher rate of return.

To increase your personal free cash flow or GAP:

  1. Increase your income
  2. Decrease your expenses
  3. Optimize #1 and #2

The really smart ones will do #3.

But let me go through them with you 1 by 1 to show you the impact.

1a. Optimize Your Expenses

For most people the expenses are an easy win. They may be unsure if they could get a better salary. A much lower hurdle is trying their best not to overspend.

In fact, they should make good spending decisions.

Buy things that cost more but last for a long time, which you use very often.

For those things that are low in your priority, make peace with it. Spend less on them.

It is OK to indulge in one of your hobby. It is a financial disaster if you have many, many fleeting interests and always spends top dollar on them. They will add up.

Be a value spender. Ask yourself why you really need that something. Find an acceptable grade of the goods and services you need, and try to spend as little as possible to purchase it.

Given the same salary, same salary growth, same rate of return of their entire wealth, the expense optimizer wins out by being frugal.

For many years after I graduated from university, I kept my expenses at slightly above university level. I provided for my family and pay down debt.

Other than that, I do not spend much.

The significance is that my savings rate, is 50%. The typical savings rate for most I know were usually less than 30% more or less.

your savings rate matter in getting rich
A 50% savings rate vs 10% savings rate (click to see larger table)

The table above compares an expense optimizer, with one that does not optimize.

Because she optimizes her expenses, her savings rate, which is income minus expenses divide by income is 50% versus someone who only has 10%.

The starting investment is $40,000 and the investment rate of return is 4%, her wage growth is 3%.

The net wealth built up at year 30 is $1.3 mil versus $428k. Even in year 5, the difference is almost 3 to 4 times.

Your Savings Rate is the biggest determinant of building wealth at the early stage. Notice that the difference between those who optimize and do not optimize expenses is very big even after 5 years.

1b. Earn More & Higher Income

The other side of the equation is to increase your income.

Your human capital is your greatest asset. Your human capital refers to your ability to work, or create a service or business. How much is your human capital? It is the aggregate of all your annual income in the future, adjusted by inflation, back to today.

If you are younger, your human capital would be much greater than a middle age or someone that is older.

But all this human capital is intangible. You have to convert your human capital into wealth assets by putting your personal free cash flow into assets that grow in value over time.

To grow your income, get into a field where there is demand in the future. And it is not a field where it will be obsolete soon. Always strive to improve your competency, add to your experience.

Build up deep competencies in certain areas where

  1. People are willing to pay you for
  2. People need it
  3. what you enjoy or find it acceptable to be doing
  4. what you can develop deep competency in

Eventually, you may be able to create products and service out of it and become an entrepreneur. You can create a side business out of it. Instead of getting paid for a fixed amount of hours you work, get paid for value you delivered.

your earnings matter in getting rich
A 7% income growth vs a 3% income growth (click to see larger table)

If we compare two persons with the same savings rate, starting income and wealth rate of return, the one that focus on enhancing his or her income growth will build greater wealth.

The person who focus on income growth will earn a compounded income growth rate of 7% a year versus the one who doesn’t (3% a year).

Initially the difference is not a lot. However, after 20 years, the difference start becoming apparent.

Of course, your income growth experience may be different:

  1. Greater income growth when you are younger
  2. Higher risk of retrenchment and stagnation when you are older

However, if you calculate the growth of salary over your working career of 30 years, it should be around that range.

My salary growth was not spectacular in the past 15 years. If I annualized my salary growth rate, my salary grew at a compounded rate of 6.6% per year.

The slight difference is that in a matter of luck, Investment Moats became sort of a side business that became income generating. So this adds on to my net wealth as well.

Learn from my experience. Do better here.

2. Build your Wealth Wisely over Time

By increasing your income and optimizing your expenses, you increase your personal free cash flow.

You consistently increased the gap.

As I have said, you have to sensibly convert your free cash flow into wealth assets. And then grow this wealth assets at a good rate of return.

Albert Einstein famously said that compound interest is the most powerful force in the universe. Einstein said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Wealth Machines - Investment Moats
Create your own wealth machine that gives you recurring cash flow when you need.

The diagram above is a more detailed version. It shows how your personal endowment fund or wealth machine would look like if you create one. (what are wealth machines).

In this personal endowment fund, you are the investment manager and wealth manager all roll into one.

These are some of the sequence of investment and wealth management actions you will perform:

  1. You put the personal free cash flow you build up (refer to the Cash from Disposable Income going in) into this wealth machine of yours
  2. You make the important financial decisions what financial assets you want to put this cash into. Why do you put into these financial assets. When to buy more, hold on to it, and when to sell or re-balance it into another financial asset
  3. These financial assets
    1. Grow their value (or crumble in value if you do not do it well) over time
    2. Pays out interest, rental, business and dividend income over time
  4. Keep the interest, rental, business and dividend income inside your wealth machine. Don’t spend it. Reinvest these income into more financial assets
  5. If you repeatedly do #1 to #4 over time, your wealth machine builds up
  6. The advantage is that as your wealth builds up, you can sell a proportion of your financial assets over time on a recurring basis. This creates a wealth cash flow that can pay for all or part of your expenses. Or for some emergency spending

You have to make some good financial decisions here. Because if you do not make good decisions, your wealth will shrink. The wealth cash flow will not come in. Too much wealth cash flow is paid out such that it puts stress on your wealth machine.

We will go into more of that later, but first let us see the significance of the investment rate of return of your wealth.

Why your Rate of Return Matters

your rate of return in investment matters in getting rich
A wealth builder compounding at 5% versus one that compounds at 1% (click to see larger table)

We have 2 person building wealth at 2 different rates.

Suppose person A focus on building wealth and was able to earn a 5% a year rate of return on her wealth.

Her cousin, person B, thought it is too risky to invest, and put her money in higher yielding deposits that earns 1% a year rate of return.

The result is that after year 15 onward, Person A greatly outperforms Person B’s wealth accumulated.

Here are some more ways to look at it.

various growth rate
Net Wealth growth at different rate of return

If we compare different rate of return, of course the higher will be better. But from what we can see, you won’t see the difference in the first 10 years. You will probably see the difference after that.

wealth building at different growth rates

The table above shows the growth in these 4 lines in detail. 3% versus 9% at 15 years is like 40% different. So is 0% versus 6%. If you go up to 20 years it is 55-60%. 25 years is 65-75%.

Compounding takes time.

Why you may not be building wealth wisely

There is a need to emphasize on building wealth wisely.

Many of our friends do well by consistently increasing their GAP, but because they are conservative, majority of their wealth is put in savings, fixed deposits or pay down debt.

From my experience, it can be challenging earning 5% a year on your entire financial net wealth or even on your portfolio.

There are a lot of personal wealth destruction going on:

  1. James boasted to you about making 100% returns on a few stock gains, but turns out that is just 10% of his financial net wealth. Overall, it is just a 10% gain. And that gain didn’t last
  2. James perhaps forgot about the stocks that was still on his portfolio that are on unrealized losses. He does not dare to take a stop loss
  3. Michael took up a course on forex trading. He thinks that this will give him the edge, prevents him from suffering from common mistakes amateurs make. He also thinks he learnt some certain tips of the trade. It turns out that trading in real life, versus simulated accounts, is very different. He blew up his $20,000 account in less than 3 months, despite the course. Luckily this is only 30% of his net wealth. The rest of his net wealth is in cash savings. From his financial net wealth, he is down 30%
  4. Louis wanted to find a way to invest to beat inflation. He learns from a Facebook group to invest in a Roboadviser through exchange traded funds. He contributed for 1 year and there were decent gains. However, he felt that the returns were “too slow”. Seeing that his friend is doing quite well investing in real estate investment trusts (REITs), he decides to sell off the holdings in the roboadviser, and invest in 3 high yielding REITs. He just happened to invest at an all-time high. The REITs subsequently lost 25% in value. He got demoralized by the experience. He tells himself he will only invest when the stock market crash. For the next 8 years he did not invest. He had a demanding job and could not always pay attention to the market. There were times when the market was down 15% and that was an opportunity but he was too busy to take advantage. So he stayed in cash for this whole while. The market was up 59% during these 8 years

James, Michael and Louis’s experiences are not unique. They can be rather common.

A lot of the main reasons is due to:

  1. Picking the Right Strategy for yourself. There are many financial instruments out there. However, for each, there are a few ways that people attempt to build wealth.
    • Some are sound strategies that give you long term positive expected returns. Some are unsound. There are no clear signs they give positive expected returns in the long run
    • Some strategies take up too much effort of your effort. For some strategies, you need to have your head plug into the financial markets for wealth building to be a success. Usually these are suited for full time investors doing it as their job. This might be right for wealth builders who are interested and willing to make this their second job. However, for those who are busy, it might not be the right match. Most are not willing to take this second job
    • Competency. For some strategies, the competency that you require to get long term sustainable positive expected return is low. For some is high. Most often wealth builders underestimate the competency required, and overrate their own competency level
  2. Behavioral. It is important to use the right financial assets but building wealth is also very mental. A lot of people could not build wealth because they cannot overcome their mental hurdles

So what should you do?

  1. Build up the financial competency to invest
  2. Build up the financial competency to manage your wealth
  3. Find a good financial mentor to learn from
  4. Find a trusted and competent financial confidant and delegate the wealth building and stewardship of your wealth to them

I do suggest that for some who have build up their GAP #4 is very good. But to know which mentor is good, who can be trusted yet competent, you need to know what you need to know.

That requires some minimum level of financial competency. You have to compound your financial competency over time just like your wealth.

If not you will be eaten alive.

Pick the right wealth building strategy for yourself

In the image below, I listed some popular wealth building strategies.

different methods to get rich
Different Wealth Building Strategies

Some of them need higher financial competency. Some needs a lot of upfront and recurring time and effort.

I have been an active stock investor for the past 14 to 15 years. I have also started in the unit trust world. So that is where I am familiar with and how I built the majority of my wealth.

For those who wish to build wealth wisely, they can look into build wealth with a low cost, passive portfolio. Select 2 low cost funds that covers the global equity and bond market. Overtime, add the free cash flow or the difference between your income and expenses to these 2 low cost funds.

Bringing it all together: Higher Income, Lower Expenses and Compounding your Money over Time

If you strive to increase your income, optimize your expenses and build wealth wisely, your wealth will grow in a different way compared to your peers.

Mary went down this path. Kate took the traditional route.

Mary:

  1. Savings Rate: 40%
  2. Starting Income: $40,000 a year
  3. Rate of return in Wealth Investments: 5% a year
  4. Income growth rate: 7%

Kate

  1. Savings Rate: 20%
  2. Starting Income: $40,000 a year
  3. Rate of return in Wealth Investments: 1% a year
  4. Income growth rate: 3%
what if you earn a good rate of return, and increase the gap? You get rich
Why Mary did better than Kate (click to see larger table)

Just by growing the GAP and building wealth wisely, Mary ended up with a lot more than Kate even from year 5 onward. In 30 years, the difference is almost $2.2 mil.

You can see that if you just get the basic wealth foundation right, your wealth will build up.

Had you not come across this and do not know this wealthy formula, how much you will be missing.

To summarize:

To increase your GAP/Free Cash Flow:

  1. Increase your income
  2. Decrease your expenses
  3. Optimize #1 and #2

Build Wealth Wisely

What Makes the Most Impact to Your Wealth?

John Rekenthaler, head of Morningstar research, wrote a piece on what matters the most to building wealth. In the article (which is behind a paywall) he list down the few ways a person can increase their wealth.

They are:

  1. Start early. Find a time machine to go back and start earlier
  2. Higher salary. Get a 25% raise to $50,000 a year
  3. Salary growth. Grow his or her salary at 4% instead of 3%
  4. Increase savings rate. Instead of saving 6% of the annual income, choose to save 8%
  5. Increase company match. The company willingly increase how much it matches the employee’s contribution rate
  6. Cheaper investment plan. Instead of 0.72% expense, switch to a plan similar but cost 0.22%
  7. Better rate of return for your investments. Get a investment that yields 8% instead of 7%
  8. Retire later. Wait 2 more years to retire, instead of 67.

John found that some of these make a greater impact to you when it comes to building wealth then others.

Here are the results:

what makes the most impact to getting rich

You will realize a few of those that make the most impact, it is also within your control

  • 1 – Early start
  • 2 – Increase your savings rate
  • 3 – Retire later

The rate of return (#6 Better funds) actually is rather small!

Let us look at why.

a. Start Building Wealth as Early as you can

You cannot turn back time.

So this one is more applicable to you young ones reading this.

If you can put away into investing & building wealth as early in your life, you can build more wealth. What many didn’t realize is that you can also put in less capital and get the same result.

start saving early to be rich

The above example shows this.

You have three person Early, Late and Early and Continue:

  1. Early started early and put in $6000 a year for 15 years then stop. He built up $613k by putting in a total of $96k
  2. Late started 15 years later and put in $9000 a year and never stop. He built up $598k by putting in a total of $270k
  3. Early and Continue started early and put in $6000 a year and never stop. He built up $1 million by putting in a total of $276k

Clearly putting in early helped. But if you can keep continue doing it, you will do alright as well.

b. Bump Up your Savings Rate

You can save near 80-100% of your personal free cash flow.

If you divide what you save over your income, you get your savings rate. Your savings rate includes what you put into investments.

The higher your savings rate, the faster you build wealth.

If your income is higher, you can have a greater savings rate. If your income is low, you will have to optimize your expenses. But you can only do so much optimizing.

your savings rate matter in getting rich
Savings Rate Difference (click to see larger table)

If we revisit the table where we compare the savings rate, you can see the different is immediately seen at the 5 year mark.

your rate of return matters
Rate of Return Difference (click to see larger table)

In contrast, the difference when it comes to rate of return is only felt after 15 years.

Your savings rate is more important than this.

For those who are pursuing financial independence for example, your savings rate in this case may matter more than your investment rate of return.

Let us see why.

How your Savings Rate and Rate of Return Matters to your Financial Independence Goal

If you ask me why do we want to build wealth, it is so that we can buy some thing later.

But I feel that a lot of us want to be in a position so that we can choose whether we want to work or not. To do that, we need a stream of cash flow that is able to cover our current annual expenses.

If you have a portfolio of investments, or what I called a wealth machine, you will be able to do that.

We can slowly build up our investments. At first, it cannot produce much recurring annual wealth cash flow. But as we repeat the Wealthy Formula that I explained in this article, your investments will grow. So is your recurring wealth cash flow.

For others, it is less about work optional but to alleviate their financial insecurity. These financial insecurity manifested when they face financial trauma in the past (typically when young). Financially insecure people do not want to have no money for food, shelter and some basic living. They don’t crave for the world. If you are like that, you may just be looking for a stream of cash flow to cover your essential expenses and a little more of the good-to-have expenses. You are seeking out financial security.

How fast can we build up our wealth to be financially independent or secure?

your savings rate matter in getting rich
How many years it will take you to be financially independent, depending on your investment rate of return and savings rate

This chart shows the relationship between your investment rate of return versus your savings rate. Observe 8 lines of different color. Each of these lines represent 8 different investment rate of return of 1%, 2%, 4%, 6%, 8%, 10%, 15% and 20%.

On the horizontal axis, we observe different savings rate (% of income channel to Wealth).

This is how it works. Suppose you make $10 from work. If you save 100% of your personal free cash flow of $6, it means that you spend 100% of the other $4. We use the standard 4% withdrawal rate to determine how much wealth you need to retire / be financial independent.

The vertical axis shows the number of years. The smaller the number of years, the faster you get to be financially independent.

Observe that when your savings rate is near 80%, all the lines bundled together. This means that no matter whether your investment rate of return is 1%, 2%, 4%, 6%, 8%, 10%, 15% and 20%, the time you will be financially independent or secure is almost the same.

As you get to a lower savings rate, say 50%, it starts to spread out. But at 50% the difference between a 1% rate of return and 20% is still within 12 years.

For most people their savings rate is below 30%. So the difference in number of years to financial independent is 14 years to 46 years.

Here is another view of the same data:

your savings rate matter in getting rich

If your savings rate is high, the investment rate of return matters less. If you cannot jack up your savings rate, you got to take more risk, increase your investment rate of return.

your savings rate matter in getting rich

In the illustration above, the solid line are different savings rate but 3.5% investment rate of return. The dotted lines are different savings rate but 7% investment rate of return. Observe that the dotted lines are pretty close to the solid lines.

It is another way of showing that if you want to take less risk with your money, increase the savings rate.

But it is Absolutely Necessary that You Learn to Invest and Manage Wealth Well from an Early Age in order to Stay Rich

The previous section may lead you to conclude that you should focus on earning more, optimizing your expenses, and boosting your savings rate.

That is true.

But at a certain point, your wealth will be so large that the rate of return will be more important.

I realize many might not have grasp this relationship so I explain more here:

  1. Focusing on Saving More Versus Focusing on Investing: Are you Being Smart about It
  2. Why You Should Not Force Yourself to Start Investing ASAP

You have to remember this.

To build wealth wisely, you got to invest and manage your wealth well. In order to do that, you need an adequate level of competency.

That level of competency cannot be acquired in a short span. Many thought they could. However, they learn the hard way by losing a lot of wealth along the way.

And it is worse when you lose your wealth when your wealth is substantial, and you have less time to make them back from your job.

Those who paced themselves by learning to invest and manage their wealth, and save well over time is able to manage their wealth well when their wealth becomes more substantial.

Those who Succeed to be Rich Do Two of These Very Well

either earn more, optimize your expenses, boost your rate of return to get wealthy over time realistically

In project management, we like to say you can only have 2 of quality, speed and cost. You cannot have all three.

What we observe is that you

  1. Earn a good income but remained frugal but do not have the time to learn to invest
  2. Does not have a high income, am rather frugal but you have the time to learn and invest. Most of all, you can earn an above average rate of return
  3. You are high income and know how to have a high rate of return, but you cannot have the time to budget or control your expenses

There are the rare few that is able to do all three well. But if you do only one of these well, it is likely you need to do that thing very very very well in order to get rich.

If you ask me I would rank myself as such:

1 Very frugal. Relatively less expenses than the standard family. This should be my greatest advantage out of the three

2. Slightly above average rate of return. We usually measure rate of return by either time weighted average rate of return (TWRR) or dollar-weighted average rate of return (XIRR). The first one is hard to calculate but to calculate the second one, there is a quick and dirty method.

My XIRR is about 9-10% over near 15 years including the un-deployed cash in the portfolio. If we measured against others, I do not think this is fantastic investment returns. However, if we measured against the general population, who have made many investment mistakes, or have generally been in low rate of return asset allocation, I think this gives me an edge.

3. My income from work would be average. But as Investment Moats became a side business, it does contribute a little.

For most, you would do very well with taking care of #1 and #3. But you should aim to be rather rounded in #1, #2, #3. Building wealth is not hard as long as you let the time aspect work for you.

How do You Stay Rich for a Long Time

Jaime Townsend knows a thing or two about how the wealthy stayed rich. Jaime helped steward the money of the rich at Lawton Partners Wealth Management in Canada.

Lawton specializes in helping business owners transition their businesses from one generation to another generation.

The one thing that he noticed that allows these people to continue to stay rich was that they manage to passed on the know-how and most importantly, the family values from one generation to another.

When the values are passed down successfully the wealth tends to follow.

You may be building the first generation of wealth, but you can learn a lot from what those that stayed rich in many generations.

We may be wealthy by getting rich fast. This can be due to our luck just having the right opportunity, at the right time. And we did the right thing at the same time.

However, what will make us stay rich is whether you acquire the financial competency to invest and manage your wealth over time. American investor Warren Buffett made most of his money after the age of 70. For most of us, we are considered infants versus that age.

In order to grow wealth, and compounding to work its magic, you need time.

This means that our financial competency needs to show up not just in 1 year but over many years. This cannot happen over night.

If you find your financial competency sorely lacking, make a resolve to build it up fast from today. If not, find someone that is competent, yet trusted to manage it for you.

Summary

This is a long post so let me summarize the formula, in slight detail:

  1. Grow that GAP or your Free Cash Flow
    1. Earn more income
    2. Optimize your expenses
    3. Balance #1 and #2 out
  2. Learn to build wealth wisely
    1. Build up your financial competency to a sufficient level
    2. Get as great of a risk adjusted rate of return as you can
    3. Reinvest your capital gains, rental, interest, dividend, business income into your wealth machine
  3. Learn what makes the most impact to building wealth
    1. Start investing early
    2. Boost your savings rate to as high as you can
  4. Learn to at least do 2 of these stuff well

I cannot promise you that you will be very very rich but this is the most generic, yet realistic way to achieve it.

If you want to get rich quick: Grow that GAP very very fast by getting into sales. That will earn you a lot. Watch your expenses well. Then at the same time, be really fortuitous to be able to build wealth at a greater than 20% a year rate of return.

For those that could not, I hope that this post serve as a guide to show you how to realistic become wealthy over time in your own way.

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