When you read about successful billionaire investors or just generally people who got rich by investing into stocks, you might get a feeling that with your limited, ordinary income it’s impossible or pointless to invest. I know that feeling well, because right now, I invest with my limited student’s income. What I also know (and would like to share), however, that you can build quite impressive wealth even with limited capital. But beware- if you already see yourself buying a Ferrari next year by following my blog (or any other blog for that matter), I’m sorry to disappoint- this is not about getting rich quickly, but consistently over time.
In the financial world, most of the things are measured in percent, including returns. For example, if you achieve 10%, it doesn’t really matter, whether you achieved it with $100 or $1 million. In the real world however, if you make 10% on $100, you end up with $10, which even though quite nice in percentage terms, it isn’t all that great in absolute terms and it certainly won’t make you rich. The question is then “How do we get to that $1 million to make 10% from?” We will need two “forces” to work for us: compounding and dollar-cost averaging.
Compound interest
“Compound interest is the 8th wonder of the world”
-Albert Einstein, allegedly
I believe most of you are familiar with the phenomenon of compound interest, but even if you aren’t, let’s take a look why it is such a wonder. Imagine you have $100 which you lend to your friend George for a year and agree that he’ll pay you +10% more as interest on the money he borrowed. After a year he comes back and gives you back your $100+$10 as interest. Now your friend Lucy comes and wants to borrow your new $110 for the same 10% interest. After a year she comes back with your original $110+$11 as interest. See where this is going? Not only that you increase the money you have by lending it and receiving interest over and over, but the interest you earn keeps getting bigger every year, because you have more money to lend out than in the previous year. This was quite straightforwardly described by Benjamin Franklin: “Money makes money. And then the money made by money, makes more money”.
Mathematically, compound interest is expressed as future value = present value × (1 + interest rate)n , where “n” denotes number of years. Just to make it clear, compounding doesn’t apply only to lending or debts, it is applied to any kind of asset with returns you can compound, including stocks. Let’s take a look at a graph from an online calculator to gain a better intuition for this.
In the inputs, I told the calculator to compound $100 by 10% every year, for 25 years. The blue line represents what we put in and the red line total value after compounding. After 25 years, we made little more than 10-times what we put in, little over $1000. That is quite impressive mathematically, but in practical, real life terms, $100 investment becoming $1000 in 25 years still won’t make us rich. But what if we contributed every month during the 25 years? That would mean that not only our pile of cash keeps getting bigger because we earn more and more on the interest, but we help the pile grow by putting additional $100 every month, earning yet more interest.
The blue line you see are our contributions ($30’100 = 25 years × 12 months × $100 + $100 initial). The red line is again our total value and notice how it keeps getting higher over time- to $119’000. Now that is something to work with already. If you’re thinking “But wait Daniel, you’re scamming me, before we got 10-times our investment and now only 4-times?” then hold on a second.
You have to realize the $30’100 we put in, was contributed over time, meaning not all money was compounded for the same amount of time. For example, the money from year 10 was working for only 15 years. If you invested the whole $30’100 in the beginning, you would also get 10-times your investment. That leads me to another point- if you have $30’000 on hand right now you can invest, more power to you and go ahead. I unfortunately don’t and I think many people reading this article do not as well. And that is the beauty of compound interest- even with little money, as little as $100 a month, which is totally doable for most people in the west, you can build a quite significant amount.
How the inputs affect the future value
Go ahead to the calculator and play with it yourself if you want- experiment with how much you save, how long and at what interest rate. I would like to point out one very important thing about compounding, which has very serious practical implications for our value investing journey. The effect of monthly saving is linear, meaning if you double your monthly contributions, your total future value will also double. What is not linear, however, is the effect of time and interest (if you want to talk about this mathematically, shoot me an e-mail). In simple terms, each additional year has higher increment than the previous one. It is obvious from the graph and it means each additional year you hold, you are going to make more than the previous year, meaning you should hold as long as possible. Just try playing with the calculator and first put in 25 and then 20 or 30 years and see how it changes drastically.
The interest rate also has a drastic effect (either positive or negative) when it is increased/decreased. Once again, try to play with it in the calculator. To end the compound interest part and make you drool, let’s draw this hypothetical scenario: you have a good job and you can invest $500 every month. You are young and you have a lot of time until retirement so you will invest for 30 years and you were also able to find a good portfolio manager (hopefully future-me) who gives you 15% consistently, every year. How would your investment look like?
After 30 years, you would end up with roughly $2.6 million. Seems unreal? For some it might be too little, but for many it is a fairy tale. And I know, not every body can put $500 aside every month and 15% even though attainable is not exactly easy to achieve and 30 years is a long time, but still, this is very real and this is how you build wealth over the long time.
Now, these examples were good for demonstration, but there is something missing, since this is purely mathematical and theoretical. When we invest in stocks, we don’t get a stable, consistent return like in this example- sometimes the stock prices go up 30% in a year, sometimes they stay at 0% or they even go negative. That is when dollar-cost averaging comes into play.
Dollar-cost averaging
Stock prices are volatile and as I said, sometimes they even stay flat or are negative. Therefore, on your stock investing journey you might encounter periods, when your savings fall quite drastically which is a huge emotional and psychological shock. You might then look at a graph of a stock or an index chart which looks like this:
and think to yourself: “Oh boy, if only I sold at the peak, the waited a few weeks and then bought again at the bottom, I would have made so much more!”. And your thinking is completely correct- it is the old saying of business “sell high and buy low” and you would actually make much more money that way. The problem is, when you’re at the peak or at the bottom, you don’t actually know you’re there! Trying to catch the the trend and time the market is extremely, extremely hard and without complex statistical processes and computations basically impossible (even then it is never 100% correct).
When you look at the chart, the peaks and bottoms look so obvious, right? You really get a feeling you can predict the next one. Not to disappoint you, but chances are you can’t. (If you can more power to you and also send me an e-mail and please teach me, for real) This is called hindsight bias and it is a very common one in behavioral finance. Even though not completely straight parallel, it’s similar to when you’re struggling with a problem (like math, accounting, coding, whatever) and you just cannot find the solution. When somebody shows you how to do it, it suddenly seems extremely simple and obvious, because you already know what happened.
Another problem which more wealthy investors encounter is that they put some considerable amount, like $1 million into the stock market, expecting to earn their 10% but suddenly, unexpected recession comes and they lose 30% in the first year and another 15% in the second. Now they are at $595’000 ($1M × (1-30%) × (1-15%)) and they have to earn whopping 68% to only break even and be where they started, so it might take another 5 years or so to get there. Thus, after 7 years, they are at incredible 0% average return. Nice.
How do we solve this problem? The answer is dollar-cost averaging. That means you do not invest everything at once, but phase it in gradually, like in our compounding example when you contribute $100 each month, taking advantage of the fluctuating prices. If they go higher- good, you’re making money. If the prices go down, like in our recession example- also good, you can buy at lower prices and thus exploit the subsequent return from the recovery. By dollar-cost averaging, we not only protect ourselves from downturns, but even use these downturns which are certain to come to get better results. Sure, you might not buy exactly at the bottom, but remember- predicting the bottoms and peaks is basically impossible for the everyday guy. (By the way, another problem at frequent selling and buying trying to predict peaks and bottoms leads to more taxes and transaction costs, more on that in another article). If we take the exact same graph and put vertical lines to indicate our buying points, it would look like this:
It might look chaotic at first, but if you look at it, you’ll see that our buying points are dispersed evenly and even though sometimes we were buying at the peak which was followed by a big slump, we took advantage of those falling prices and didn’t stop buying, thus reducing our costs and improving our returns.
There is one final basic assumption we have to recognize: dollar-cost averaging works only if the asset you are buying will eventually recover and continue rising indefinitely. It seems obvious, but it has to be said- if you pick a stock which declares bankruptcy or is just generally in a bad shape and keeps falling, you can dollar-cost average all you want, the price just won’t recover. Thus you either invest in an index which is said to rise “forever”, like the S&P500 index (which is basically a bet on the American economy, watch Warren Buffett explain it here) or you invest in a portfolio of quality stocks you think will be here forever and will be also rising forever (such stocks I am trying to find).
Real word example of dollar-cost averaging
Let’s take a look at real world data and dollar-cost averaging on the S&P500 index (ticker $SPY) from the period from 2000 to 2020, contributing $100 each month and seeing with how much we would end up.
Source: https://www.buyupside.com/alphavantagelive/dollarcostavecomputeav.php?symbol=spy&amountinitial=100&amount=100&start_month=10&start_year=2000&end_month=10&end_year=2020&submit=Calculate+Returns
In total, we contributed $24’000 and by magic of compound interest and dollar-cost averaging, we were able to get total value of little more than $72’000, 3-times our investment. Considering this is “only” for 20 years and that S&P500 is quite low risk (meaning lower expected return), I think this is very impressive.
What’s even more impressive, that the starting period was at the peak of dot.com bubble before the burst, we survived the 2008 financial crisis and also the Covid-19 slump in March/April 2020. But because we exploited the falling prices and were buying periodically and regularly, thus getting more return from the subsequent recovery, we averaged our dollar costs. Now once again, you can play with this calculator and try putting up more, trying different stocks or asset which yields more and see with how much you end up.
The bottom line is, you can start investing even with $100 if you do it right with compounded interest and dollar-cost averaging. There are key things to remember and some words of caution:
- in order for this to work, you have to invest for the long-term (at least 20+ years)
- you have to be really consistent
- you cannot try to time the market
- you should ignore the fluctuations on the market and try to focus on periodical contributions and exploiting lower prices when they fall
- notice on the compound interest graphs how most of the wealth comes in the late period. Therefore, I repeat, focus on the long-term and hold as long as possible
What assets can I buy periodically to start dollar-cost averaging?
If you’re reading this blog, I think you consider yourself value-oriented and long-term oriented. In that case, you basically have two options:
1. If you’re very conservative or if you don’t want to think at all, your best and easiest option is some major US stock index*, like the S&P500 ($SPY) which is a basket (or rather smoothie as I like to call it) of the 500 biggest American companies. The historical average return is around 7-8% per year, which I think is very nice for knowing the bare minimum about investing and a few clicks every month. Hell, many active investors who dedicate their life to picking stocks and managing portfolios struggle to beat this benchmark! (Hopefully won’t be my case).
If our assumption about ever growing US economy holds, this is the way to go. Beware! By no means I am saying you will get 7-8% every year, regularly. This is not bond investing and stock and indices truly are more volatile. Thus, you will have +20% years, -20% and everything in the middle. The key-point here is average return, implying you have to invest long-term for this average to manifest itself. It even might happen that you begin investing before the next recession– in that case, psychology and persuading yourself to continue investing and believing in the stock market is very difficult ( I will write an article about this), but you should always try to look at falling prices as opportunity for you to purchase at lower cost.
*if you are from Europe, you are legally restricted to buy American ETFs. I will talk how to “bypass” this in the next section.
2. If you’re a little less risk averse in order to capture higher returns and want to think a little, you can invest in a balanced portfolio of high quality stocks. This is my case and the basic idea is the same- I try to find companies which I believe will grow indefinitely, are very profitable, not likely to go bankrupt and are available for a good price, thus I try to find stocks which adhere to the assumption we mentioned earlier (ever rising value and price). I am saying you have to think a little, because you have to know what you’re buying (buyer beware!) to make sure the stock you own truly will rise forever. That requires thorough financial analysis together with qualitative analysis of the company, its products and the industry it operates in (you can check out how such analysis looks here).
I also said little less risk averse, because individual stocks and companies just have many idiosyncratic risks (financial stability, industry, regulation, competition etc) and their stocks are also much more volatile and can fall significantly. But, as I said, I am trying to eliminate these risk by doing my homework, focusing on the long-term, accepting the volatility of prices and use it as an opportunity to buy a quality company cheaper and then (hopefully) enjoy the higher return for taking on a little more risk.
How to do it in practice
Disclaimer (please read): I am NOT affiliated, associated, authorized, endorsed by, or in any way officially connected with eToro Ltd., or any of its subsidiaries or its affiliates. The official eToro Ltd. website can be found at https://etoro.com
Now if you’ve been paying attention, you see that I said you can start with $100, but you Googled $SPY index and see one share costs around $337. Am I lying or what? Actually, no. Thanks to modern technology, many discount brokers have offers for retail clients as you and me, which allow us to buy partial shares on a crowdfunding basis. That basically means that if you want to invest only $50 into $SPY every month, you can- you just don’t own the whole share but only 15%. This allows you to start building wealth and invest in stocks or indices you like.
There are many brokers like this, also depending where you come from. I come from Europe and therefore I use eToro and even though it looks like a paid promo, it really isn’t and I couldn’t care less what broker you sign up with. My experience is that in the beginning, everything seems so complex and difficult and I had to research everything myself, therefore I am just sharing what works for me so you don’t have to.
I like four things about eToro:
- you can buy partial shares
- super fast and easy set up and deposit
- they offer stocks from around the world and also some smaller stock around $2-5 billion market cap.
- there are no fees and commission if you are a long-term holder
The downside of eToro is there is a social aspect to it and a lot of distractions to push you into trading, showing you stellar results of traders, etc. which all diverge from the goal of long term value investing. Another one is you can’t really buy smaller or lesser known stocks under $2 billion, but I can live with both.
If you are from Europe, you cannot legally buy American ETFs as an individual retail investor, which means you cannot buy SPY as I explained earlier. There are two ways to solve this:
- you choose some European based investment firm or financial advisor, who is able to buy American ETFs as an institution and manage the account for you.
- how I deal with this problem with “betting on American economy” is that I buy partial shares of Berkshire Hathaway Inc. ($BRK.B), which moves very similarly to the S&P500. This isn’t the perfect solution, however, it makes sense to me for two reasons: Berkshire is big enough to be well diversified and has many of the top American stocks from the S&P500, that is why it moves so similarly and second, since it is a value investment company managed by my role models Warren Buffett and Charlie Munger, they choose only stocks which are consistent with value investment approach, i.e. they exclude some lower quality stocks from the S&P500 and include others, which they consider valuable.
Summary
Let’s summarize what we learned if all of this was new for you (or you didn’t read the article) in a way we can implement the knowledge and adhere to the rules we set.
- compound interest interest works like magic- let’s use it to our advantage to build wealth
- it works better in longer time horizons and the longer you hold, the faster and more you are going to earn (exponentially)
- to mitigate the effect of economic downturns and to start with limited capital, we implement dollar-cost averaging
- when the prices fall, we use this opportunity to buy at this lower price and average out our costs and gain more on recovery
- for dollar-cost averaging to work, the asset we buy will have to rise indefinitely. Therefore, we choose carefully what we buy to make this assumption hold
- we invest either in a stable index (like S&P500) or we choose individual stocks which are stable, profitable and will rise over time
- if you have truly limited capital (like myself) of only 100$ a month or maybe little less, we choose discount broker who allows us to buy partial shares
- we invest for the long run.
- most importantly, we you buy something for investment, you have to know why you are buying it and you have to decide for yourself in the end. Never let anybody tell you (not me or any other blogger, your uncle and especially not the financial media) what to buy or not
I hope I gave you something to think about and hopefully you start thinking about your future-self and family and how you could build the necessary means to be financially secure. There are many ways to invest, but for me personally or for the average person without deep financial knowledge and limited time and resources, I believe this is truly the most secure, the least demanding and the most rewarding way to go, if you stick for the long run. If you made it till here, thank you for reading. I am more than open to any feedback you might have, whether comment, question or criticism so don’t hesitate to contact me. Stay vigilant.
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