The three key investing variables
Once you have defined your investment goal and the associated time frame, you are ready to establish an investment plan in order to achieve your objective. The three variables that will determine the amount of capital you will realize in your investment program are:
- Savings rate
- Rate of return
The longer your investment program time frame, the greater the power of compound interest. For example, if you invest $1,000 and assume a 10% rate of return, after 5 years you would have $1,610.51, after 10 years $2,593.74, after 15 years $4,77.25 and after 20 years $6,727.50. As you can see, compound interest has a big impact on the growth of your capital as the interest you earn each year is added to the principal. An easy way to calculate how many years it will take your money to double at a fixed annual interest rate is to use the “rule of 72”. All you have to do is divide 72 by the yearly rate of interest. For example in order double $1000 invested at 10% it would take 7.2 years (72/10).
The more capital you are able to save and contribute to your investment program, the greater the potential growth of your portfolio. Saving the necessary capital to fuel your investment objective means that you must live below your means. Ideally, try to put 15-20% of your income into your investment program. If you are not able to achieve this immediately, try building up to this amount over time by increasing the amount of your savings rate when you receive pay increases. For most individual investors increasing their savings rate early in their career will have the largest impact on their final portfolio balance.
Rate of return
The rate of return of your investment program is driven by amount of risk you are willing to take when selecting your investments and the costs associated these investments. Risk and expected return have a direct relationship so if you want to increase your expected rate of return you must also increase the amount of risk. This is done by increasing the percentage of stocks and reducing the percentage of bonds and cash equivalents in your portfolio.