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Thursday, 30 January 2014

Making that first Million Rand...

All wealthy people are investors in one sense or another. If you want financial independence, you have to acquire the habit of investing and managing your investments. The average South African doesn't even earn a million over ten years – and that's before paying all the bills. Even the average person in the top decile (top tenth) has to work for four years to make a million after tax – again, before deducting the cost of living. If you're in the ninth decile (ie, better off than 80% of South Africans but not in the top 10%) it will typically take you over ten years to earn a million rand after deductions. After buying groceries, paying the mortgage and putting petrol in the car most people don't have a lot left over. So to accumulate a million rand, in cash, unencumbered, yours to do what you like with, is not a trivial matter for most South Africans.

You have probably heard the expression that “the first million is the hardest”. This has nothing to do with learning how to make money and somehow mastering it after the first million. In fact, it is equally hard to save the first R1 million as it is to save the first R100,000
On the other hand, we never say that the first R100 or the first R1000 is the hardest. Why is this?
It has to do with Benford’s law. The simplest explanation I can think of is that the increase from R1m to R2m represents an increase of 100%. Conversely, the increase from R2m to R3m is 50%, R3m to R4m is 33%, …. and 9 to 10 is 11.1%

Of course, if you already have a million, it's a lot easier to make another million. All you need is an investment with a return of around 10% per annum and seven years later your one million has turned into two million (provided you haven't been taxed to death along the way). Even better, find an investment that gives you 15% per annum and your money will double in less than 5 years. Money makes money.

But that first million, that's the challenge. If you put away R4 000 a month and achieve 10% annual compound growth, it takes over eleven years of disciplined saving to end up with a million. And where are the savings accounts offering 10%? A rate of half that would be more realistic, especially after tax. At a net 5% per annum it takes over fourteen years. And how many people can afford to save R4 000 a month anyway? If you save R2 000 a month it's going to take you 23 years, and R1 000 a month… more than three decades.
So what's the alternative to this demoralising scenario?

Rate of Return

If you want to make a million by saving and investing, you need to understand that your rate of return is the key factor. The difference between a return of 7% per year and 15% per year is a decade – it takes 27.5 years to turn R1 000 a month into a million at 7% a year, but only 17.5 years at 15% per year. (I'm sure you'd like to make your first million in less than 17.5 years, but we'll get back to that in a moment.) As I said above, if you can afford R2 000 a month and your rate of return is 5% per year, it will take you nearly 23 years to make a million.

The long-term stock market rate of return is between 14% and 16% (it varies depending on the exact time period used). This is  based on the market average; by definition, therefore, on a consistent basis, half of all listed shares are doing better than this – some a lot better. But even the market rate of return improves things considerably. At the stock market average, instead of waiting 23 years, you can turn R2 000 a month into a million almost ten years sooner.
My point is that, compared to conventional saving, if all you achieve is the average market return, investing in shares is likely to halve the time it takes you to achieve your financial objectives (roughly speaking).

Unit trusts capitalise on the power of long-term stock market returns. As at May 2012, for example, the average annual return of the top 50 equity unit trusts was around 20% per year over 10 years, compared to a market average of around 14% per year. And listen to this – at 20% per year your money doubles in less than four years!
The good news is that you can do even better than this. Much better, in fact. As a private investor, you can exploit opportunities that are too small for fund managers. In the words of Warren Buffet, "It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
At a return of 50% per annum you can turn R2 000 a month into a million in less than seven years. Or R4 000 a month into a million in less than five years. Or R1 million into R10 million in less than six years.

Keeping it Real

Let's assume you can't achieve 50% per annum! After all, Warren Buffett is an exceptional investor. Let's assume, rather, that as private investors we can do just slightly better than the market average – that we can achieve 20% per year. This is a realistic objective.

Now I'd like to be able to show you a way to make that first million in ten minutes or a couple of years, but the reality is that it takes time. Consider this – if you put R2 000 under you mattress every month, after 12 years you'll have R288 000 in your bed. You'll also have a very uncomfortable lump under your back, but that's a different issue. R288 000 is a far cry from a million. So although 12 years seems like a long time, it's actually quite remarkable that by adding an investment return of 20% per year your savings of R288 000 will turn into a million over the same period.

What can you do to reduce the 12 years? Obviously saving more money every month would help, but if you can't afford more than R2 000 a month, the best thing you can do is improve the rate of return. At a return of 25% per year you'll shave two years off the program. Get it up to 30% per year and you can do it in nine years (having put away only R216 000).
I'm not going to lie to you – if you don't have any capital, it's really not that easy to make that first million in much under eight years (not unless you can save R5 000 a month or more, which is not realistic for most people). Anybody who tells you otherwise is either lying or has been exceptionally lucky in the past.
The great news is that, once you have some capital, it gets much easier. Once you've got that first million, you're on your way. After that is really is feasible to double your capital every three to four years.

Finding the Return

The only place you can consistently get returns of around 15% per annum is the stock market. (Some people will argue that property can also do this for, but that's only true when property is debt-financed, which brings its own set of risks and challenges.)
Before you get the wrong idea, let me emphasize that stock market returns fluctuate a great deal. Most years, on average, the market goes up – sometimes a little, sometimes a lot – but every few years the market actually goes down. So when I say that the market can consistently give you a return of 15% per year I do not mean that you can expect this if you go into the market just for one year! However, you can expect around 15% per year – on average– if you invest in the stock market over the long haul (at least five years, preferably ten or more).

To get the 20% (or better) return that we want we have to select above-average shares. Talking simplistically, the market average (that 15% per year I keep mentioning) includes the performance of all shares – the half that are below average and the half that are above average. If you invest predominantly in above-average shares it stands to reason that you'll get above-average performance. And the beauty is – simplistically speaking – that, by definition, one out of every two shares is above average!
How do you find above average shares? The answer is simple – by identifying above average businesses.
Never forget that shares represent ownership in companies. In the long run, the share price of a company can only keep going up at 20% per year (or more) if the underlying business grows at 20% a year (or more). There are certainly times in the stock market when sentiment causes a disconnect between share price movement and business performance, but this kind of disconnect is always relatively short-term. Over the long haul, any company that doesn't grow its profits will suffer a falling share price.
Obviously, to identify above average companies you need to know something about their businesses. You need to know what they do and whether management have been successful at growing sales and profits in the past. You need reason to believe they can keep growing sales and profits in the future. And to do this, you need a way to access the right information quickly and efficiently.

A Quick Summary

This post has a lot of per year' figures. You might be thinking – 16% a year? 20% a year? Is it really such a big issue?
The answer is a resounding Yes. Seemingly small changes in your annual rate of return are really important – don't make the mistake of thinking that a few percent here or there makes no difference. For example, R1 000 a month earning 16% a year turns into R1.6 million over 20 years. Not bad. But at 20% a year it turns into almost R2.7 million! That seemingly small difference means two-thirds more capital at the end of the day.
Couple this with the fact that, as a private investor, you can do slightly better than the market average and you have a recipe for success. All you need are the right tools for finding those shares that will be in the front half of the field.

Happy Investing :)