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The Power of Compound Growth and Why You Won’t Save Your Way to Retirement
24 January 2022
Written by Aaron Alston – Financial Adviser

We are often told in our working life to work smarter, not harder.  This often involves better managing your time, knowing what needs to be done and focusing on a high priority task so you can focus on one task at a time.  The same philosophy can be applied to investing: have a focused strategy, knowing the key to accumulating wealth is using your savings and surplus cashflow to invest growth assets and repeating the process over and over.

Example 1 – Saving to retirement

John and Mary both aged 40 have a goal to replace their after-tax income in retirement which is approximately $100,000 p/a.  They are currently saving $20,000 per annum with $120 000 in savings and $20 000 put aside for everyday expenses.  They would need approximately $2 million in assets at retirement, which at 5 per cent per annum, would give you a return of $100,000 per annum to live on.  Whilst John and Mary are doing well to be saving $20,000 per annum it would take them 100 years to accumulate $2 million ($2 million/$20K p/a).  Not much chance of seeking the desired retirement they were after.  This is the definition of working harder not smarter.

Quite often the hardest part of the financial journey is taking the first step.  Regardless of age, gender, or our background, we all have to start somewhere.  By accessing someone else’s money (e.g., the bank) it allows you to leverage your financial position with the objective to control a larger asset than you would otherwise hold with the hope of achieving greater investment returns.

Example 2 – Using savings to invest in growth assets

John and Mary decide that rather than saving their way until retirement, they will invest.  As indicated earlier, they have $120 000 in savings.  They purchase a residential investment property for $500 000 plus $20 000 purchase costs.  To avoid Lenders Mortgage Insurance (LMI) they contribute a 20% deposit ($100 000) and $20 000 for costs.  The bank lends them 80% of the purchase price which equates to $400 000 (see table 1.1 below).

John and Mary now control a $500 000 asset through the power of leverage. Let’s say the property was in a high growth area and doubled in value over 10 years.  In 10 years’ time it would be worth $1 million.  John and Mary’s initial equity of $100 000 would now be worth $600 000.  I have assumed in the below example that the investment debt hasn’t reduced to purely illustrate the growth and the properties are neutrally geared after all costs (see table 1.2 below).

Example 3 – Using available equity in Property 1 further to purchase another property

John and Mary decide to access the equity they have accumulated in their 1st investment property to buy another property and repeat the same process again.  To keep things simple, I have assumed they purchase another property for $500 000.  They access their available equity of $100 000 plus $20 000 costs to ensure they don’t pay LMI (see table 1.3 & 1.4 below).

John and Mary now control $1 500 000 of investable assets through the power of leverage.  Let’s assume again that both areas doubled in value over 10 years.  In 10 years’ time property 1 would be worth $2 000 000 and property 2 worth $1 000 000.  Again, I have assumed that the investment debt hasn’t reduced to purely illustrate the growth (see table 1.5 below). 

By now you can see the effect of compound growth over time at play.  John and Mary now aged 60 have now accumulated a whopping $2 080 000 in equity after 20 years.  I have kept things simple to illustrate the effect of compound growth and the power of leverage.  There are several factors at play when it comes to investing in property including: researching and buying an asset that will grow in value (this involves time at diligence), managing your investment expenses and cashflow annually (can’t emphasis this point enough), spending less than you earn and investing with a focus on the longer term.

SAVING v INVESTING

If John and Mary never took the first steps to invest and attempted to “save their way” to retirement, they would accumulate $400 000 over 20 years saving at $20 000 p/a v building a $3 000 000 property portfolio.  John and Mary’s available equity is $2 080 000.  Say John and Mary decide to sell both investment properties and be debt free.

They would have a $2 000 000 capital gain because they purchased both properties for $500 000 each ($1 000 000 total). As they have held the asset for longer than 12 months, they would qualify for a 50% discount (reducing their gain to $1 000 000 total).  Even if both John and Mary were in the highest possible tax bracket, they would pay approx. $470 000 in capital gains tax still leaving them significantly better off ($2 080 000 equity less $470 000 capital gains tax & sell costs) than where they would be if they kept their money in the bank. 

Summary

  • Make your money work smarter not harder.  Saving your way to retirement is working harder not smarter.
  • The hardest part of investing is often taking the first step.
  • Use someone else’s money (the bank) to utilise the power of leveraging with a focus on the long term to achieve greater investment returns.
  • I have used property in this example to illustrate the power of compound growth, however there are various ways to invest including purchasing commercial property, starting your own business, investing into the share market, investing into superannuation etc.
  • Do your research and ensure you have buffers available for sufficient cashflow.




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