“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
Introduction
The path to financial freedom can often seem daunting and beyond reach but with the right approach it can be turned into a simple process with a high probability of success. The key to this success is to harness the power of compounding which is the payment of interest upon interest, upon interest, and so on, ad infinitum. The Compound Growth & Income portfolio featured on this site is my own compounding machine and is a journey that I have been covering publicly for over 10 years now. During that time, my returns have averaged over 20% per annum.
But this portfolio cannot and should not be copied by anyone else. The conviction in my portfolio holdings has been established over many years. My risk tolerance is different from others. My financial circumstances are different from others. My skill set and circle of competence are different from others. To this end, I have set up a separate Compounding Machine site on substack to help others build their own unique compounding machine in pursuit of financial independence.
The Power of Compounding
Compounding is the payment of interest on interest or when investing in trading companies (known as equities), it is the reinvestment of dividends that creates the compound effect and this is accelerated when combined with capital growth. The very best companies are able to generate surplus profits that can be both reinvested in the business for future growth and also, make a regular return to shareholders via the payment of dividends. The capital growth is driven by increased earnings (profits) which in turn drives increased dividends which then creates the opportunity for accelerated compounding. It becomes a virtuous circle!
In the early years of reinvesting dividends the returns can seem quite mundane but over time the combination of dividend reinvestment and capital growth help to create a snowball effect on the size of your portfolio, if left uninterrupted. Depending on your lifestyle needs, the same compounding machine can then be used to fund a retirement that keeps pace with inflation.
Tax Wrappers
The legitimate avoidance of tax is a key aspect of compounding returns. That is, the less tax you pay, the more money that is available to reinvest and grow the size of your portfolio. In the UK, Individual Savings Accounts (ISAs) are a key vehicle for growing your returns free of both capital gains and dividend tax and ultimately, withdrawing money free of income tax. For many individuals there is also the option of using a Self Invested Personal Pension (SIPP) where tax relief is provided at the front end but when the time comes, withdrawals are subject to the payment of income tax.
Pound Cost Averaging
During the growth or accumulation phase when you are adding money to your compounding machine, you have the benefit of Pound Cost Averaging which is making regular additions periodically (e.g. savings from employment). That is, you are able to benefit from both rising and falling prices of the natural volatility that occurs in the stock market. Equities tend to rise over time but occasionally the market experiences a sell-off or correction. At these times, the regular saver is able to buy more shares or units at a lower price. It is this time in the market that is likely to be more beneficial than trying to time the market.
Accumulation versus Drawdown
Typically, what often happens with retirement strategies is that people focus on growth (and perceived higher risk) during the accumulation phase and income (and perceived lower risk) during the drawdown phase. The entire basis of The Compounding Machine debunks this theory and focuses on total returns regardless of which phase you are at. The difference is that in the accumulation phase dividends can be reinvested whereas in the drawdown phase dividends can be withdrawn to provide an income. This does not detract from the underlying investment still compounding by growing both profits and dividends over time and therefore, continuing to grow the portfolio over time.
The Safe Withdrawal Rate
If you are asking yourself questions like; When can I retire? How much do I need to retire? How long will my money last? It is important to understand the safe withdrawal rate. That is, the rate that you can safely withdraw from your portfolio each year without running out of money and whether this amount meets your own lifestyle requirements. Ideally, your safe withdrawal rate will be aligned with the natural yield of the portfolio (i.e. covered by dividends being received) so that the underlying portfolio continues to grow even when you are drawing an income from it.
The global equity benchmark that we use within The Compounding Machine yields around 1.5% which means you can expect an income of £15,000 for every million pounds accumulated. For many people, that is unlikely to be sufficient and one thing that we do within The Compounding Machine is offer ideas on how to increase the natural yield of the portfolio while still compounding returns. Typically, this means that we target a natural yield of 3% to 5% overall.
Sequencing Risk
One of the challenges faced when moving from accumulation to drawdown is sequencing risk. While volatility can be the friend of the compounding investor during the accumulation phase, it can be their enemy in the early stages of the withdrawal phase. That is, if you move from accumulation to drawdown at a time of heightened volatility, you might find yourself exposed to the negative compounding effect of withdrawing funds from a falling portfolio. One way to mitigate this is to only withdraw the natural portfolio yield but I also advocate planning for the transition a couple of years ahead by withdrawing the portfolio’s dividends into cash savings, thereby providing a buffer to protect against sequencing risk.
Building Your Own Compounding Machine
I have set up The Compounding Machine to help others navigate this journey in pursuit of financial independence. While no individual investment advice is provided as everyone’s circumstances, skill set and tolerance for risk are different, the site does provide some pretty cool features to help and inspire you to build your own compounding machine. It includes,
- A model portfolio constructed and run by yours truly.
- Regular ideas for investment trusts and ETFs
- Monthly stock screens to find individual company compounders
- Individual stock reports and company analysis, supported by AI
- Exclusive subscriber podcasts
I hope you find the value compelling because it’s entirely FREE! Why not head over there now and subscribe so that all new content can be delivered directly to your inbox.
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