By John Ardill
With all of the uncertainty in our world, you may have gotten out of the habit of making these six concepts work for you. Time to get back to basics!
1. COMPOUND INTEREST
Albert Einstein said that compound interest is one of the Seven Wonders of the World.
I agree. I also see compound interest as the ultimate equalizer. It will relentlessly work for you – or ruthlessly punish you without regard.
It’s all about discipline and time: about how we earn interest on our investments or pay interest on our debt.
Let’s say you make 10% this year on a portfolio of $1,000. At the end of the year, the portfolio will be worth $1,100. This means that when you earn interest next year, you’ll be doing so on a larger amount of money—without having invested a single extra dollar. As the years pass, you’ll earn interest on interest on interest. It’s as if a snowball rolling downhill has become an avalanche.
That’s the magic – the wonder, as Einstein would say – of compounding.
It is a tool that’s especially powerful for younger investors. There is a classic example that demonstrates this: imagine someone who invests even a small amount of money, starting when they are 18, and for just a decade. By the time they retire, they can end up with a bigger lump sum than someone else who invests more – but waits until their mid-30s to start.
Here are the specifics: Alice invests $5,000 a year from the age of 18 until her 28th birthday, and then doesn’t add anything else. Thus she has put aside a total of $50,000. Bob waits to start investing until he’s 30, and then sets aside the same $5,000 every year for the next 30 years. On the surface, it looks as if he’s doing better than Alice.
But Alice’s $50,000 investment, left untouched and assuming a steady annual return of 7%, will leave her with more than $600,000 by the time she hits 60! Bob, on the other hand, deposited three times as much ($150,000) but the value is less ($540,000)!
Note that there’s an ugly flip side to the wonder of compounding: if you must pay interest rather than earn it, you risk paying interest on interest. Over time, you can owe far more than you borrowed in the first place. You become the investment that is making someone else wealthy!
2. GOOD DEBT
Yes, there is such a thing has good debt. Good debt is when you take the money you borrow and use it to make more money than the borrowing cost (plus, sometimes the interest on borrowing is tax deductible). This is why borrowing to buy a home often makes sense: each month’s mortgage payment brings you closer to outright ownership of an asset whose value should appreciate over time.
What if you want to buy a car? Should you pay cash or borrow? Well, it depends: if you have cash invested in a high-yielding portfolio, you may want to consider a car loan with low interest rates (this would be good debt). Why stop the compounding on the high-yielding investment?
3. PAY YOURSELF FIRST
This is so simple. But how many people actually do it? With every paycheque, before you pay anyone or anything else, pay yourself 10 to 20% by investing it in your large, long-term goals.
Make this automatic, like I do, by setting up an automatic deposit with your financial institution – and then watch how your money grows and compounds into retirement. If I had to remember every month, or consciously make the decision every month to invest this money, it would not have happened.
4. DIVERSIFICATION
Unfortunately, regardless of whether you have a low or high risk tolerance, all investments come with some risk – and that is why diversification is a widely-accepted investing strategy. But ask yourself this question: who has ever become truly wealthy from being diversified?
My observation is that most very wealthy people did not get there by being diversified. Consciously or unconsciously, they had more of their money in their business, or in some other asset that they knew well. Once they made their money via that business or other asset, that’s when they became more diversified, so they would not lose the capital.
And so we should be asking ourselves: How can we take advantage of these facts?
5. LIQUIDITY
They say that having an emergency fund is one of the best ways to preserve financial liquidity. Fifty thousand dollars in a money market account, for example, to meet an unexpected need. But think about the cost of sidelining $50,000 for years, and ask yourself: is there a better way to run an emergency fund?
Personally, I would pay down my mortgage with the $50,000 and apply for the largest line of credit I could get against my house. The line of credit gives me greater control over the equity in my home, and I have the $50,000 working for me.
If this is done right, I do not believe I have incurred greater risk.
6. REGULAR REVIEWS OF YOUR FINANCIAL PROGRESS
On any long journey, you sometimes need to stop and orient yourself to make sure you have not drifted from your intended outcome or goals. A semi-annual or annual review should be macro in nature, taking into consideration many things that may have changed: health, income, a big lifestyle purchase or changes in goals.
A major lifestyle purchase is an especially big issue. Should you pay cash or borrow the funds? The answer to this question will have a big impact on the long-term outcome of your finances.
And, due to your beliefs about money, your answer may not be the correct one!
SUMMARY
The effective use of these essential concepts requires you to be ruthlessly honest about your abilities and limitations—and to accept that every financial decision involves trade-offs and will have lifetime consequences.
As well, the way you use these concepts will depend upon your unique situation and the economic environment.
If some lights went on for you while reading this article, call us to see how you can sharpen your financial literacy – and efficiency.
Thanks for reading,
John.
John Ardill
Founder and Mentor
Ardill Group
Direct: 1 416 400 5882
Office: 1 905 907 7000
