Set aside funds for a rainy day

In my first article of a series exploring why the rich get richer and if the not so rich can benefit from emulating them, I considered the reasons why rich families increasingly want to set up family offices, and what we can learn from this. In this article I cover a couple of factors which make a big difference to rich families.

We all know that if you have enough income from other sources to reinvest the income from your investment portfolio rather than spend it, your portfolio will grow faster, but most human brains cannot easily take on board the power of this effect driven by compound interest. To quote Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn’t... pays it.”

For instance, £1m invested in the UK equity market 30 years ago would be worth £3.7m now with income spent, but after inflation it is only £1.6m. But with income reinvested (gross of tax) it would be worth £8.7m, or £3.8m after taking into account inflation. It seems extraordinary that from a portfolio yielding just a few per cent, 60 per cent of the return in this period will have come from compounding income. Part of this powerful effect comes not from compound interest alone but from another mathematical curiosity: the enforced reinvestment in the market at regular intervals. Because the income stream will be fairly steady, you will be buying more shares when the stock market is low than when it is high.

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If they are wise, and not too extravagant, rich families will try to set aside at least part of their wealth and take no income from it. Preferably they will identify a tax structure which allows the income to roll up tax-free for a very long period so as to defer income tax. In a generation’s time, assuming the investments have been managed sensibly, they will find that they have achieved very considerable growth over inflation.

The corollary to this is that for most investors who need the income from their investments to live off, there is only a pretty modest chance that their portfolio of shares will actually beat inflation at all. It is a sad fact that most investors have the very unrealistic view that their portfolio, despite spending all the income, will keep pace with inflation. Part of the reason for this is that the total fees for managing the portfolio will probably amount to a pretty high percentage of the assets. Unfortunately as Mr Einstein pointed out, compound interest works both ways and the compounding effect of fees will eat up very large parts of the portfolio return over long periods. In my previous article I pointed out ways in which the rich use their family offices to reduce fees to the minimum and there is a lesson in this for all of us.

Of course there are a few, very few, really talented investors who have the skill and temperament to make a lot of money out of investing such as Warren Buffett. Interestingly, that ‘Sage of Omaha’ was quoted as saying “investing is forgoing consumption now in order to have the ability to consume more at a later date”. One of the ways he analyses companies is to see if they can reinvest their free cash flow back into the operating business while maintaining the return on equity. In this way he is effectively harnessing the wonder of compound interest.