Understanding the six forces that affect how your money grows, and how they may pull you and your money in different directions—often at the same time—can help you maximize your gains over the long term.
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For many Canadians, learning investment basics can lead to smarter choices and, ultimately, a better retirement. A good starting point is understanding the fundamental elements that determine investment success or failure. These elements can be summed up in a simple equation I call “The Wealth Formula.”
Six powerful forces will determine the sum of your future wealth: three “Wealth Builders” and three “Wealth Killers.” Their impact will pull you and your money in different directions—often at the same time—working either to grow or shrink your wealth. Small variations in any one of these opposing forces can have an enormous influence on your ultimate results.
All else being equal, the more money you save and invest, the more you end up with…right? Of course. Saving and investing more today, and regularly over time, means more wealth, perhaps significantly more wealth, in the future. But while that may be obvious, it isn’t easy. Saving is hard work!
Investing is a long-term game. Decades long. Assuming a positive rate of return on investment, the longer the time period over which you save and invest, the better.
OK, another obvious point: The higher the rate of return on your investments, the better your result. Of course, higher rates of return come with risk. In order to achieve better long-term rates of return, investors must accept more volatile short-term results.
Powered by the magic of compounding and fuelled by reinvestment, the combination of longer time periods and high rates of return can produce incredible outcomes. But what about those Wealth Killers?
Often only partially disclosed or buried deep in the fine print, investment fees are “stealth” Wealth Killers. Without realizing it, millions of Canadian mutual fund investors are losing up to 50% or more of their lifetime investment returns to fees.
Just like fees, taxes can severely undermine wealth-building magic. And the complexity of our Canadian tax rules seems to stretch to infinity. But there are a few simple steps you can easily take, such as using TFSAs and RRSPs, to minimize the wealth-killing impact of taxes.
Consumer prices tend to go up over time and, as the years pass, it takes more money to buy the same goods and services. You have no ability to influence inflation; you simply have to beat it.
Let’s look at a simplified example of how The Wealth Formula works.
Michael invests $10,000 through a regular (unregistered) account in a mutual fund, which earns an average of 6% annually before embedded fees of 2% per year. He loses half of his remaining annual 4% return to tax and reinvests the balance. Meanwhile, Sarah invests $10,000 through a TFSA in an index ETF which also earns an average of 6% annually before embedded fees of 0.2% per year. She pays no tax and reinvests her annual net return of 5.8%.
Assuming annual inflation of 2%, how will Michael’s and Sarah’s investments perform?
Return after fees
Increase in purchasing power
After one year, despite a 6% gross investment return, the three Wealth Killers—fees, taxes and inflation—completely erase Michael’s gains. Given lower fees and the tax shelter provided by her TFSA, Sarah is able to achieve a 3.72% increase in her real purchasing power.
What happens if we extend these results over a longer time frame? Through the power of compounding, a $10,000 investment earning 6% annually would be worth $57,435 in 30 years. But after fees and taxes Michael’s investment grows to just $18,114, which means he only keeps pace with inflation. (After 30 years of 2% annual inflation, it would take $181 to purchase the same basket of goods that costs $100 today.) Michael has not gained a single cent in real purchasing power. On the other hand, Sarah’s investment grows to $54,271 which, after inflation, gives her triple the purchasing power of her original investment.
There is some complexity to investing, but understanding investment basics, including The Wealth Formula, will enable you to make smarter decisions and can lead to a more prosperous future for you and your family.
Larry Bates is the author of Beat the Bank: The Canadian Guide to Simply Successful Investing and is an investment advisor with Aligned Capital Partners Inc.