The Power of Percentages

Investing is all about small percentages.

The difference between a successful and an unsuccessful investor is a few percentage points a year, every year.

As a rough rule,

• 4% or less a year before inflation is made by an average investor,
• 5% a year before inflation is made by a cautious investor,
• 7.7% a year after inflation has been available for the last 106 years to an investor who bought an Australian shares index fund or the equivalent and never did anything else,
• 20.3% a year (average achieved between 1965 and 2008) before inflation was enough to make Warren Buffet one of the three richest men in the world.

Small percentages make a vast difference over time

I can not stress enough how important it is to fully appreciate the effect of percentages and compounding.

Really understanding this can make a tremendous difference to your life. It can enable rich people to become a great deal richer. It can enable people who think they are poor or do not have any money to achieve financial freedom. Of course equally - and more commonly - not understanding this can have a very negative effect on your finances.

Increase your percentage by reducing fees

Increase your percentage by increasing returns

Set your children up for life with $5,000

Increase your percentage by reducing fees

• Minimise your ongoing fees.
• Minimise your taxes.
• Minimise your trading.

It really is that simple.

Minimise your ongoing fees

It is really easy to squander 3-5% a year by not taking care of fees. With managed share investments there are four sets of fees that you will face:

The above may look a little extreme but it happens all the time and in fact circumstances can be even worse. For example:

In certain cases a financial planner stands to gain a great deal of extra money for him or herself by steering you towards one investment rather than another.

The whole scandal around the Westpoint "investments" was that financial planners were selling them as "safe" investments whilst the planners were receiving TEN percent commission. It is impossible to have a short or medium term "safe" or even good investment that is paying 10% commission up front plus ongoing commissions.

Good investment practice is not always and only about paying the least possible fees, but it is important that you understand the issues and the significance of fees and percentages.

Sometimes you need to pay fees because some of the best investments are not available without fees. If you (or your financial planner's) non emotional research shows that investing in a fund is costing 1% extra but that fund is likely to increase your returns by 2%+ in the long term, then clearly that is an intelligent choice.

In the above example we are referring to funds such as Dimensional that are based on a proven methodology.

However, be very careful of choosing such an example based on any mistaken belief that one particular manager is better at "guessing" the market or "timing" investments. There is a great deal of literature that supports the argument that this is a foolish strategy.

It seems impossible to consistently find the very few winning investment managers before they have a winning track record. Once they have a winning track record they usually become so expensive that investing with them is again a losing proposition. In addition, many managers with a winning track record were just lucky and subsequently become expensive and no more likely to be lucky again than any other manager.

The above is one of those occasions where cheaper (lower management fees) is usually better.

Minimise your taxes

There are a few things to watch out for here.

• personal buying and selling of shares can trigger a great deal of negative tax implications
• investing in a fund that buys and sells shares a lot can have the same effect, just more hidden
• there are often ways of structuring your investments, income, loans, superannuation and insurance in a much more tax effective way.

Often simple restructuring can quickly pay for your financial planning fee. Minimising your taxes and maximising temporary opportunities is also an ongoing process with the constant changes introduced by the government.

Minimise your trading

Surprisingly, this is a big one. Every time you trade, you incur taxes and fees.

These taxes and fees hurt over the long term but the excessive buying and selling hurts even more.

As human beings we seem to be hardwired to buy and sell at the wrong time. We buy when investments are expensive and we sell when investments are cheap. The more buying and selling we do, the more we compound these mistakes and the worse we do as investors. (Dalbar and, more technical, Bogle - in the Bogle article look for the Heading "Fund Returns vs. Investor Returns").

According to research, the above mistake can cost us about 8% a year when buying shares directly and about 6% a year every year when buying share-based investment funds.

Increase your percentage by increasing returns

The other critical issue to understand is how risk and return are related.

Click here for an explanation of how risk and return are related and how this knowledge can help you to maximise your returns whilst investing within your own comfort zone.

The Power of Percentages for very young people

A simple example of how to turn $5,000 into $1.8 million

Small percentages can set up a young person for life:

As investors, very young people have a huge wasting asset - time. A few thousand dollars invested properly could set them up for life. For example:

Giving a young person $500 (to $1,000) a year in the right way for five years could lead to between $350,000 and $1.8 million in today's dollars once they retire.

What is giving the right way here?

• You give them $500 to put in their superannuation account as an undeducted (non-concessional) contribution and tell them to ensure it is invested in an Australian shares index fund,
• you ask them to put in another $500 ($10 a week or you can put in the full $1,000 yourself),
• the government then puts in a further $1,500 under the superannuation co-contribution scheme. These $2,500 now have 45 years to grow.
• If you do the above for five years in a row from ages 18 to 22, you have $12,500 growing and compounding over 45 years.

The reason for those eye popping numbers - $350,000 and $1.8 million - is that Australian shares have had such huge returns for a very long time.

Australian shares have returned 11.6% after inflation over the last 20 years (since 1985, source: Perpetual and Kaplan). Over the very long term, from 1900 to 2005, including the great depression and two world wars, Australian shares returned 7.7% after inflation (source: Arrowstreet Capital and Perpetual).

The difference between the returns of $350,000 and $1.8 million is in the percentage the shares grow at:

• $12,500 growing at 7.7% (if the returns are the same as for the last 106 years) becomes $350,000 over 45 years
• $12,500 growing at 11.6% as the returns have averaged over the last 20 years becomes $1.8 million in today's money over 45 years

Another big advantage is that once these young people hit middle age they will not need to worry about their old age. By the age of 45 they would have between $80,000 and $200,000 in their super in today's money plus all the contributions they have added themselves. This should normally be enough for their retirement if invested properly.

There is a big difference between arriving at 45 and having very little for retirement to reaching 45 and looking forward to be being set for a grand retirement. When you have enough money, life's challenges look a lot less bleak and going out and starting your own business looks a lot less threatening - there is always your super in retirement to fall back on.

$100,000 in Australian shares can lead to over $4 million dollars in today's money

This table shows the difference a few percents make over the long term and the very long term.

The assumption is $100,000 invested at the beginning and the amounts achieved after a certain number of years. Fees and taxes are ignored for this exercise. However, if you cater for fees and taxes the differences are even more startling - actual taxes paid are much higher for Cash than for shares for most investors.

All percentages are after inflation, i.e. so-called real returns. (Except for the 'Inflation' column, which is shown for comparison).

Note how the average US share investor hardly increases his or her capital even in the very long term.