While keeping expenses below revenues seems simple enough, many people today live beyond their means. Due to misguided monetary policy, society has favoured debt accumulation over saving.
And as a strategy, it has worked well for decades. That’s because the return on assets (shares, property, bonds etc) were well in excess of the cost of debt. So leverage worked.
Borrowing at 7 per cent to purchase an asset growing at 10 per cent – or more – is an easy way to make money. And as more people borrowed, the weight of money kept pushing asset prices up. This was particularly the case in residential property – the most leveraged of asset classes.
Reverse Compounding and Property Investments
Home loan borrowing costs are around 7 per cent. Assuming you put down a 10 per cent deposit and borrow the rest, you’ll need an annual return of at least 6.3 per cent to keep your head above water. If house prices fall (which is a likely scenario after years of increases) reverse compounding kicks in.
For example, if you put a 10 per cent deposit down when buying a house, it would only take a 10 per cent decline to wipe out all your equity. Meanwhile you continue to pay 7 per cent interest on the debt. Reverse compounding.
Reverse Compounding and Share Investing
I believe borrowing to buy shares is only slightly less risky. This relates to the differences in the cycles between property and shares. Share prices peaked in October 2007. House prices peaked around midway through 2010. In other words, shares offer better relative value than housing.
However, margin loans (borrowing to buy shares) are expensive. The interest rate charged can be as high as 10 per cent. If you buy opportunistically, I think shares have the potential to beat that 10 per cent hurdle over the long term.
But not by much. And with the market expected to remain volatile, there is a very good chance of getting margin calls (being forced to sell) at precisely the wrong time.
Compounding – Weighing Up Risk and Reward
In other words, it’s a bad risk/ reward trade-off. Borrowing to buy assets in the hope of making easy money is yesterday’s strategy. It won’t work in the years ahead.
You can see the very nasty effects of reverse compounding in Europe. Take Spain’s economy for example. While Spanish government debt is still relatively low, the market knows the banking sector in Spain is insolvent and will require government money at some point. So Spain’s debt situation is much worse than it looks.
These countries got to this point from years of over spending. They financed this ‘dis-saving’ by borrowing more and more. Their debt compounded until the market finally decided to turn the easy money tap off.
Now they are at the point of bankruptcy and social upheaval. Reverse compounding is as nasty as compounding is beneficial.
A Look at Reverse Compounding in the US
Consider the US, which is on the path to taking the concept of reverse compounding to epic levels:
It has total outstanding federal public debt of US$15.6 trillion.
In 2011, despite low interest rates, the interest expense on the debt hit a record US$454.4 billion. Given the size of the US economy is around US$15 trillion, interest expense is still manageable, representing about 3 per cent of national output.
But as a percentage of total Federal tax revenue the situation doesn’t look so benign. It’s estimated the government will extract US$2.5 trillion in taxes in 2012. If we assume interest expense of around US$450 billion, nearly 20 per cent of the tax take goes towards debt servicing. It can only get worse from here.
I think the US is still a few years away from a genuine debt crisis. But if it keeps compounding its debt it is a certainty to get there. And it will come quickly when it does.
A huge debt pile is manageable when interest rates are very low. But if interest rates all of a sudden went to 6 per cent because of a loss of confidence, US debt-servicing costs would be well over US$1 trillion per year. At that point, the option would be to raise taxes sharply or print money to pay for the interest expense. Neither of these is good.
Are You Safe From Reverse Compounding?
Unfortunately, you cannot entirely avoid the deleterious effects of reverse compounding at a national or international level. When financial ignoramuses run governments around the world there’s not a lot you can do to avoid the fallout.
I bring up reverse compounding because it’s an obstacle you need to consider in your own path the wealth creation. You can avoid reverse compounding at an individual level by simply staying away from debt. Or only get into debt when you have a high level of confidence it will work for you. (I would include debt to finance your own business in this definition.)
But this strategy will not work in the coming decade. Borrowing to purchase assets will result in reverse compounding in the years ahead.
The Compounding Strategy For the Future
What will work in this coming decade is a simple compounding strategy.
Which brings me to the most important – and simplest – point when it comes to compounding. It’s called saving. If you don’t save you can’t compound your wealth.
Successfully compounding your wealth in this sort of economic environment is difficult. But it can be achieved if you keep three things in mind:
- Invest internationally – I think the Australian index will meander in a wide range and ultimately go nowhere. I also think the Aussie dollar is overvalued against a range of currencies. Given this view, I think you need to look further afield for opportunities. Adding some international companies to your portfolio will add currency diversity too.
- Be patient. Wait for opportunities. Focus on quality business rather than a cheap stock price.
- Buy gold. It’s one investment that many people dismiss as being over. But this metal is quietly going about its business of getting rid of as many investor as it possibly can before resuming its next leg up.
Compounding requires patience. Whereas most people want to get rich quick. That’s fine. But understand getting rich quick is a low probability outcome.
Growing your wealth through compounding has a very high probability outcome. If you’re prepared to save and keep my three guidelines in mind, I have no doubt you will become – and more importantly stay – wealthy.
Greg Canavan
Editor, Sound Money. Sound Investments.
From the Archives…
What Newton Knew About House Prices …That the IMF Should
2012-05-11 – Kris Sayce
Why a Greek Exit From the Eurozone Could Be Great News For Markets
2012-05-10 – John Stepek
Why Europe Will Ditch Green Energy
2012-05-09 – Kris Sayce
Why It’s Time to Buy Gold
2012-05-08 – Dr. Alex Cowie
Why You Should Be Watching Japan’s Economy
2012-04-07 – Dan Denning
