Did an interesting exercise today. I know this is obvious stuff but I think it's still worth reminding ourselves the power of compounding over a long period and what a small difference of 2% in investment returns can make.
Generally speaking for majority of people their working lives are approx 40yrs. Somewhere between 20-25 years to 60-65 years.
To keep this exercise simple I will assume person A invests $1 million in a low cost index fund at age 25 as person A believes in trying to keep costs down to the minimum.
Person B also invests $1 million but in an actively managed fund which charges a higher costs of nearly 2%. This fund beats the index over several years but also lags the index in many years making it somewhat similar to the index over a long period. I am talking 30-40 years here.
Going by the long term returns it is not unreasonable to expect low cost index fund to generate approx 9% returns and actively manage fund to also generate similar returns but because of higher fees (performance, transactions etc) investors loses around 2% on fees there by only returning them around 7% net over the long term.
No additional funds are invested over those 40 years.
Here are the result
Person A
After 40 years the $1 million earning 9% will be worth approx $36 million
Person B
After 40 years the $1 million earning 7% will be worth approx $16.3 million
Less than half.
Moral of this exercise is don't underestimate even a small percentage gain to your investment returns. One of the easiest way to gain small percentage gain is to reduce your investment costs. Over long period you will see the difference.
Paying tax on your investment returns can be treated as investment costs. Hence, the same argument can be made when discussing Cashflow vs Capital Growth investments. If given the choice always invest for Capital Growth due to it's favourable tax treatment by governments. Over long period you will build wealth much faster since you will have more $$ compounding for you whereas Cashflow investor will be giving away big chunk of their investment returns to the tax man. Berkshire Hathaway has never paid a dividend in 50 years (except once) and the results are there for everyone to see. People should read Buffett's latest letter to shareholders where he justifies his decision of not paying dividend and why shareholders are better off than if he paid a dividend.
I know few people will come up with argument that future Cashflow is certain whereas CG is not. I agree, but I also think that if you are investing as opposed to speculating and therefore buying quality assets which you can with great certainty say will be worth a lot more in future you can invest for capital growth.
To put it simply, if quality assets are desirable to people today they will be desirable to people 10-15 years from now. As the economy grows and peoples salaries increases they will be willing to pay more for quality assets in future years thereby providing you with the capital growth. I think this is a reasonable assumption to make when investing.
Happy investing
Cheers,
Oracle.
Generally speaking for majority of people their working lives are approx 40yrs. Somewhere between 20-25 years to 60-65 years.
To keep this exercise simple I will assume person A invests $1 million in a low cost index fund at age 25 as person A believes in trying to keep costs down to the minimum.
Person B also invests $1 million but in an actively managed fund which charges a higher costs of nearly 2%. This fund beats the index over several years but also lags the index in many years making it somewhat similar to the index over a long period. I am talking 30-40 years here.
Going by the long term returns it is not unreasonable to expect low cost index fund to generate approx 9% returns and actively manage fund to also generate similar returns but because of higher fees (performance, transactions etc) investors loses around 2% on fees there by only returning them around 7% net over the long term.
No additional funds are invested over those 40 years.
Here are the result
Person A
After 40 years the $1 million earning 9% will be worth approx $36 million
Person B
After 40 years the $1 million earning 7% will be worth approx $16.3 million
Less than half.
Moral of this exercise is don't underestimate even a small percentage gain to your investment returns. One of the easiest way to gain small percentage gain is to reduce your investment costs. Over long period you will see the difference.
Paying tax on your investment returns can be treated as investment costs. Hence, the same argument can be made when discussing Cashflow vs Capital Growth investments. If given the choice always invest for Capital Growth due to it's favourable tax treatment by governments. Over long period you will build wealth much faster since you will have more $$ compounding for you whereas Cashflow investor will be giving away big chunk of their investment returns to the tax man. Berkshire Hathaway has never paid a dividend in 50 years (except once) and the results are there for everyone to see. People should read Buffett's latest letter to shareholders where he justifies his decision of not paying dividend and why shareholders are better off than if he paid a dividend.
I know few people will come up with argument that future Cashflow is certain whereas CG is not. I agree, but I also think that if you are investing as opposed to speculating and therefore buying quality assets which you can with great certainty say will be worth a lot more in future you can invest for capital growth.
To put it simply, if quality assets are desirable to people today they will be desirable to people 10-15 years from now. As the economy grows and peoples salaries increases they will be willing to pay more for quality assets in future years thereby providing you with the capital growth. I think this is a reasonable assumption to make when investing.
Happy investing
Cheers,
Oracle.
