Over the years I’ve had many people ask me for advice for someone wanting to improve their financial position. Below are a few of the concepts of how people generate wealth over time. These may seem like elementary concepts but can be valuable for someone new to investing.
Savings trumps investing
The first concept I want new investors to learn is that savings is more important than investing initially. I can illustrate this with a simple example of Jack Jones who is 35 years old and has $50,000 in capital to invest in his RRSP.
Let’s make the assumption that Jack can make six per cent a year on his investments. If Jack does not contribute to his investment account then his account balance at the end of the year is $53,000.
In talking to Jack, we encouraged him to think about saving $500 per month (or more), this would contribute $6,000 per year to his RRSP. The investment return only contributed $3,000 to annual growth whereas the savings was $6,000 in one year, far greater than the investment returns.
If Jack is serious about improving his wealth over time, then savings initially is the key until the account value gets built up.
The snowball effect
Visualize yourself as a kid making a snow man. You would start with a small snowball and then begin rolling it on the ground. As it rolls it gets larger. The more you roll it, the more rapidly the growth occurs. The snowball effect can be described as both good and bad.
The bad snowball effect relates to when people get themselves into a bad debt situation.
Examples of high interest debt include: delinquent bills, credit cards, non-favourable business loans, car loans, and other personal loans. Spending beyond your means is a sure way of destroying wealth accumulation.
If interest costs and debt are spiralling out of control then it leaves little discretionary cash flow after each pay cheque. In the worst scenarios, net worth is declining every month.
The good snowball effect positively impacts investors who have accumulated significant savings/investments. Up above we mentioned that savings is more important for Jack. Below in a table we have outlined the growth for Jack’s portfolio over 10 years, assuming he doesn’t contribute and makes a six per cent annual rate of return.
| Beginning balance | Return | Ending balance | Accumulated earnings | |
|---|---|---|---|---|
| Year 1 | $50,000.00 | $3,000.00 | $53,000.00 | $3,000.00 |
| Year 2 | $53,000.00 | $3,180.00 | $56,180.00 | $6,180.00 |
| Year 3 | $56,180.00 | $3,370.80 | $59,550.80 | $9,550.80 |
| Year 4 | $59,550.80 | $3,573.05 | $63,123.85 | $13,123.85 |
| Year 5 | $63,123.85 | $3,787.43 | $66,911.28 | $16,911.28 |
| Year 6 | $66,911.28 | $4,014.68 | $70,925.96 | $20,925.96 |
| Year 7 | $70,925.96 | $4,255.56 | $75,181.51 | $25,181.51 |
| Year 8 | $75,181.51 | $4,510.89 | $79,692.40 | $29,692.40 |
| Year 9 | $79,692.40 | $4,781.54 | $84,473.95 | $34,473.95 |
| Year 10 | $84,473.95 | $5,068.44 | $89,542.38 | $39,542.38 |
After 10 years, Jack’s net worth would have accumulated to $89,542. Over a 10-year period, Jack’s net worth increased only $39,542.
Another example: Jill Jones has $1,000,000 in an investment account at the beginning of the year. Below we have put a similar table for Jill assuming she earns the same six per cent rate of return and makes no further contributions.
| Beginning balance | Return | Ending balance | Accumulated earnings | |
|---|---|---|---|---|
| Year 1 | $1,000,000.00 | $60,000.00 | $1,060,000.00 | $60,000.00 |
| Year 2 | $1,060,000.00 | $63,600.00 | $1,123,600.00 | $123,600.00 |
| Year 3 | $1,123,600.00 | $67,416.00 | $1,191,016.00 | $191,016.00 |
| Year 4 | $1,191,016.00 | $71,460.96 | $1,262,476.96 | $262,476.96 |
| Year 5 | $1,262,476.96 | $75,748.62 | $1,338,225.58 | $338,225.58 |
| Year 6 | $1,338,225.58 | $80,293.53 | $1,418,519.11 | $418,519.11 |
| Year 7 | $1,418,519.11 | $85,111.15 | $1,503,630.26 | $503,630.26 |
| Year 8 | $1,503,630.26 | $90,217.82 | $1,593,848.07 | $593,848.07 |
| Year 9 | $1,593,848.07 | $95,603.88 | $1,689,478.96 | $689,478.96 |
| Year 10 | $1,689,478.96 | $101,368.74 | $1,790,847.70 | $790,847.70 |
The larger the accumulated savings balance, the larger the potential accumulated earnings and the greater the snowball effect of accumulating wealth, especially over time. It is tough to get the full snowball effect until one has saved enough to get the base level of capital.
Although Jack and Jill both made six percent, Jill was able to accumulate $790,847.70 of additional wealth, while Jack only accumulated $39,542.38. Jill is fully able to take advantage of the snowball effect in a positive way. The magic of compounding investment returns is magnified when you have accumulated enough savings — making money on money.
Investing rather than speculating
Investing is the concept of thinking longer term and picking solid well run companies. Speculating is more short-term type trading that may or may not have the desired long term outcome. The probability of making a mistake and moving backward when speculating is higher.
We would rather encourage savings and investing rather than speculating.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138. greenardgroup.com
