A combination of various factors are incredients for success
Returns on investments (e.g. in company stocks or Exchange Traded Funds (ETFs)) matter a lot in the context of the wealth accumulation process of individuals. So, of course its highly reasonable to put an eye on the portfolio performance on an annual basis.
However, over the long run, when it comes to building a large, powerful investment portfolio there are several elements significantly more important than just the the returns of realized/unrealized book gains and dividends collected in relation to the invested capital. After all, it’s the Compound Effect that makes people wealthy over time. And that is kind of a cocktail of several factors.
The Savings Rate defines how much one is able to invest
The percentage of someone’s income (take-home pay, dividends, interersts) that remains as savings after all spendings are made (for housing, food, insurances etc.) is called the Savings Rate. It’s the single most important measure when it comes to Personal Finance and is THE most important factor on how fast a investment portfolio will grow, as it’s sets the ability to put money to work on a regular basis.
Let’s look at that measure and chrunch some numbers in a few examples.
For instance, someone earning USD 50’000 per year with dividend income of USD 5’000 annually (we assume here the numbers net after taxes), spending USD 40’000 per year has a Savings Rate of 18 %.
As said, the higher the Savings Rate, the higher is the amount that can be invested on a regular basis.
In our example the person would be able to invest USD 15’000 each year. Now let’s assume, these investments would have a total performance of around 8 % (in book gains and dividends).
And now let’s contrast it with someone having the same net income (USD 55’000 p.a.) but higher annual spendings of USD 50’000 – resulting in a Savings Rate of 9 % – but also being very skilled at finding “highflying stocks” in the tech sector. Altouhgh his/her investment returns are significantly higher, over 20 % per year that skill alone is not a recipe for superiour success as there is only little money left after costs in order to invest.
Assuming equal income, having a Savings Rate of 18 % to invest for 8 % returns is superior to a Savings Rate of 9 % combined with a performance of 20 % (USD 1’200 versus USD 1’000).
So, focusing on increase the Savings Rate – either through boosting income and/or slashing costs – is much more powerful than focusing on investment performance.
When it comes to investing, Quality is the Key Factor
One of my favorite Warren Buffet quote puts this aspect perfectly:
“Our favorite holding period is forever.”
Now, this principle says it all about the importance of the Quality. It implies, that you are positioned into investments that grow over time and get stronger and stronger. Because there is absolutely no sense in holding on positions that are mediocre and then even lose their competitive edge over time.
So, looking for businesses with
- a very strong and unique market position, for instance on the back of valuable brands with pricing power on its products and with
- a competitive innovative edge and the willingness to learn and adapt over time
is absolutely essential.
Look for businesses that have proven over and over again, that they have not become complacent, that they want to thrive and are still at the forefront of their industry.
Put low cost and high quality ETFs in your investment portfolio or make a list with the storngest and most reliable businesses, such as:
- The Coca Cola Company
- The Walt Disney Company
Long term thinking always trumps short term results
The main driver of the compound effect is time. The holding period of high quality productive assets such as ETFs or individual stocks is what matters most.
Focusing just on investment performance on an annual basis has the tendance to sell winning positions all too fast. But time works in favour of wonderful businesses. So wether you are holding individual shares and/or ETFs, just let winning stocks run.
So, when someone has the skill of identifying great stocks returning 20 % and more annually, congrats! But again, that skill alone won’t pull the needle in the long term wealth accumulation process, if he or she sells out strong positions in the investment portfolio or makes constant changes through rebalancing which not only is bad for the returns over the long haul but it is also likely to increase the risk position.
Investment legend Charles Munger brilliantly brings it to the point: “the first rule of coumpounding: Never interrupt it unnecessarily.”
Giving in the temptation of selling high-quality stocks just to lock in profits is a recipe to forgoing larg investment profits over time.
Never forget, that time in the market beats timing the market!
Don’t forget, that TIME IN THE MARKET beats timing the market
Never worry about getting into a stock position or selling a holding at the “right time”. That’s just impossible. Even more, it’s not only costly (transaction costs) but it is severely to the disadvantage of your performance and most important: it increases risk.
No one can time the market. Timing the market means trying to predict the future. There is a high probability of failure with this strategy, though, because it’s impossible.
The less you change, the better (see next point).
Follow your own strategy you feel comfortable with and stick to it
Focusing just on short term performance of an investment portfolio and constantly comparing it with benchmarks and other strategies is to the long term detriment of you wealth accumulation process. Always keep in mind, that everyone talking about his or her investment approach is to some extent biased. Which is completely natural.
Your personal investment strategy has to work FOR YOU in any environment. What good is it to be 100 % in stocks with an excellent performance, when you immediately need cash due to a private urgency, forcing you to sell some of your best holdings?
Determine for yourself, how much are you able to invest on a regular basis in high quality investments and make sure you only put money to work you don’t need for the long haul. And then, not only be patient but practically forget your portfolio! Just let your investments do their work. Like that, you have implemented the recipe for long term wealth accumulation.
There are several factors that are by far more important than the stock performance on an annual basis. It’s the amount one is able to put to work for a longer time period that matters. It’s about being consistently In the Market and letting the investment compound over the long haul. And as long as you are here in a range of around 8 % per year, you are perfectly fine. It’s absolutely okay to be average when it comes to investing. You don’t have to swing to the fences. On the contrary: the less efforts you do, the better.
You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.