In the previous post, we looked at what compounding is, how it works for and against you and what you need to know about it. This time, we'll look at what you need to do to succeed with compounding.
Everything you Need to DO
1. Cash is NOT an Investment
Cash is not an investment, because by removing the asset price appreciation element of wealth building you are severely hamstringing your growth. The income on your investments desperately wants to be useful to you, so buy real assets (stocks and shares, or occasionally property). Stocks and shares bring volatility of course, which tends to be less present with property investments.
2. Balance Yield and Growth Depending on Life Stage
Yield and growth, while not being mutually exclusive exactly, don’t usually come together, at least not consistently. My example of 4% yield and 5% growth is unlikely to happen in reality – it’s worth noting that investments never behave in straight lines and produce the same growth and yield year after year.
If you invest for all-out growth, you’re likely to get an uninteresting yield from your investments. Conversely, go for all the income you can get, and the chances are your growth will suffer.
It’s worth looking at the fund factsheet for past performance and current yield, but remember past performance is not a guide to future performance. For regular saving, err towards growth. Adding more money to the pot to buy more shares means you’re not relying on yield.
When you are no longer saving, then there’s an argument for erring towards a higher yield and lower growth, as a lower growth investment is likely to be less volatile. You’ve already achieved your savings goal.
Of course, there are as many arguments against these strategies as in their favour, and many more aspects to the decision than just yield vs growth. See my conversation with Abraham Okusanya about retirement investing, and his excellent new book on the subject, ‘Beyond the 4% Rule’.
3. Compound Using Regular Savings and Treat Market Drops as Opportunities
Buying more shares each month with your regular savings can only be a good idea. You end up with more assets to do your compounding for you, and that’s got to be a good thing. Add that benefit to the pound cost averaging you’ll get, buying more shares when prices are depressed and fewer when the price is high, and you can see the sense in it.
My buddy Andy Hart, creator of the excellent Maven Money podcast, likes to bang on about behavioural finance. And he often says that market declines are to be celebrated as they provide an opportunity to buy more assets at depressed prices.
This is the practical reality of legendary investor Warren Buffet’s oft-quoted saying of “be greedy when others are fearful, and fearful when others are greedy. We should shun the normal negative response to market events, because a drop is an opportunity to buy more stuff to compound.
4. Watch Your Costs
Costs are a big deal and they need to be watched. That’s at all levels of your finances, from unnecessary spending to the costs and taxation of your portfolio.
Missed part one about compounding? Or are you ready for the next post?