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Michael Pope Blog post by Michael Pope

The Impact of Capital Growth

In an earlier newsletter, we identified that there are many different investment vehicles available to use in a strategy designed to deliver long term wealth creation, and that these different approaches differ in a number of key characteristics, including :

  • their upfront and ongoing cost in terms of both time and money,
  • the extent to which they can be funded with borrowed money ( or “leverage” ),
  • their anticipated return in terms of their growth in value over time,
  • their anticipated return in terms of any income they may provide,
  • the anticipated variability of the return over time ( referred to as “volatility” ),
  • any Income Tax or Capital Gains Tax implications,
  • the level of risk of losing your investment, and
  • the amount of knowledge or skill required.

 

In this newsletter, we will look at the impact of the growth over time in the value of an investment asset on the long term outcome of our investment strategy, as this is one of the key factors influencing the end result.

The first important aspect of growth of an investment asset is that it is compounding in nature, that is, the growth in any year adds to the value of the asset and increases its value.

To illustrate why this is important, consider putting $1,000 into a Term Deposit at a Bank and receiving Interest at the rate of 6% per year.  So each year you would expect to receive $1,000 x 6% = $60 in Interest and after 10 years you would have received a total of 10 times $60 or $600.  This is often referred to as “simple” interest.

However, if you had added the Interest you received to the value of the Term Deposit and reinvested it, instead of taking it in cash, then at the end of the first year, you would be investing $1,060, and you would expect to receive $1,060 x 6% = $63.60 in Interest.  Over a ten year period, your Term Deposit plus Interest would grow to $1,790 – an increase of $790, over 30% more than in the case of simple interest.  This is the power of compound growth at work.

But what if you were able to get a higher return on your Investment than the 6% used in this example?

If you were able to get a return of 7% per year, then at the end of 10 years, your $1,000 would have grown by $967 – 38% more than simple interest.  A return of 9% would see you end up with a gain of $1,367, 52% more than simple interest, and a return of 10% would deliver a gain of $1,594, 60% more than simple interest.

So, the higher the return on your Investment, the more growth you end up with, and the more that compound growth delivers compared to simple interest.  The “Rule of 72” is a mathematical shortcut used to estimate the effect of compound growth on the value of an investment.  If you divide the annual percentage growth rate into the number 72, the result will tell you approximately how long an investment will take to double in value.

So an investment growing at a compound growth rate of 6% per year can be expected to approximately double in value every 72 ÷ 6 = 12 years, and an investment growing at 9% can be expected to approximately double in value every 8 years.  This may not sound like a huge difference, but consider an investment asset held for 24 years.

An investment growing at 6% will double in the first 12 years and then double again in the next 12 years, meaning that it will be worth around four times its starting value.  An investment growing at 9% will double in the first 8 years, double again in the next 8 years and then double again in the next 8 years, meaning that it will be worth around eight times its starting value, or twice as much as the investment growing at 6% per year!

This illustrates why compound growth, and in particular the growth rate achieved, is a critical factor in the success of a long term wealth creation strategy, and why Empower Wealth considers the choice of investment asset to be such an important decision in implementing an investment strategy.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Wealth Projection Simulator which allows you to see the effect of asset selection decisions by modelling the effect of different compound growth rates, together with all the other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

We will be demonstrating some of this analysis and its impact on an investment strategy at our next Property Wealth Forum on Wednesday 7th March from 7:00 to 9:30pm at the State Library of Victoria, LaTrobe Street, Melbourne.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation by registering at our website or just give us a call.

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