Conventional wisdom holds that you need a pile of cash before you can begin to invest successfully in stocks. Investing via direct investment plans turns that notion on its head and proves the opposite can be true. Whether you have $100 or $100,000, what's most important is when you start to invest and how you invest. A Fool beginning with $100 can be in a better position to succeed than a Wise man with $100,000.
How can this be?
Because discipline, time, and compounding are the three main contributors to successful investing -- not the amount of money that you have to invest.
A new investor possessing little money to start, the right discipline (which many investors unfortunately lack), and more than a few years to be invested (ideally a decade or longer) can use compounding to build a nest egg that tops "big-money" investors' results. The first necessary asset is discipline. How do you acquire it? Many investors are their own worst enemies.
Enter: one great solution.
Direct investment plans provide a framework for successful investing. The discipline includes staying invested at all times, not trading actively, and -- for most investors -- consistently saving money and buying more shares. Direct investing supports all three disciplines. The plans are created for asset accumulation, not made for quick selling, so it is rare that you make a snap decision to dump stock when the market tumbles. The plans also make it easy (and usually free) for you to invest more regularly. Given this, you come to see market declines as long-term opportunities.
The S&P 500 has risen nearly 11% annually, on average and with dividends reinvested, since 1926. This compares to the 2.8% yield that an average savings account will provide. The stock market has been the best-yielding investment available over its history, yet thousands of people have lost money on it. Why? Because it is time that awards you gains.
The stock market declines many years, but when it will cannot be predicted, so a majority of the time, trying to make forecasts is costly. Studies show that a majority of the stock market's gains take place during a condensed period -- over a number of combined weeks any given year. If an investor misses those weeks, results suffer. An investor needs to stay invested in leaders, and history demonstrates that the longer you're in, the better.
When you couple the power of a good investment discipline with time, you get a one-two punch. Discipline combined with time results in the desired Foolish outcome: compounding.
To compound your money is to build wealth on top of wealth, as well as on top of your original investment. If you start with $1,000 and you earn 10% in year one, you'll earn $100 and have $1,100. If you earn 10% again in year two, you'll earn $110, not just $100, because your investment base has grown. The following year, another 10% gain will represent an even larger dollar amount earned. Compounding is simple but magical math.
Discipline + Time = Compounding
When you combine the three criteria necessary to build wealth, you get the equation that headlines this paragraph: Discipline + Time = Compounding. In the end, compounding of your dollars is the goal. Write the equation down (D+T=C) and tape it to your computer screen if you too actively watch and worry about stocks. You shouldn't!
The following tables show how various compounding scenarios play out.
The first Fool below began with $500 and added $100 monthly (like Drip Port). The total amount invested at the end of 20 years was $24,500. After 40 years: $48,500. The second Fool (table two) invested $1,000 to start and added $200 per month.
Value when annually growing: 7% 11% 15% Year 1 $1,745 $1,820 $1,866 Year 5 7,868 8,816 9,911 Year 10 18,313 23,194 29,741 Year 15 33,120 48,052 71,528 Year 20 54,112 91,031 159,581 Year 30 126,055 293,806 736,098 Year 40 270,637 899,929 3,295,955
Value when annually growing: 7% 11% 15% Year 1 $3,550 $3,640 $3,732 Year 5 15,736 17,632 19,822 Year 10 36,626 46,388 59,483 Year 15 66,241 96,105 143,057 Year 20 108,224 182,062 319,163 Year 30 252,110 587,612 1,472,196 Year 40 541,274 1,799,589 6,591,911
There are two important lessons to take away from these tables:
- time matters greatly
- your annual return matters greatly
A 4% difference in your annual rate of return can make the difference between a $3.2 million portfolio and a $900,000 portfolio. And as for time, notice how most of the value is created in the later years. That is how compounding works, and it's why we try to buy our stocks at fair valuations.
If you have questions, visit the related links above and visit us on the Drip boards also linked above. Invest Foolishly in 2001 -- and help others do so, too. Perhaps send them this column to start! Fool on!
-Jeff Fischer, TMF Jeff on the boards.