Today, I want to touch on a topic that I assume all of my readers are interested in — how best to grow wealth.
I’ve chosen real estate investing as a vehicle for wealth creation, but I’ve never really taken the time to explain why I’ve chosen real estate investing and why I believe it is (one of the) great ways of achieving financial freedom. Hopefully, this article will explain why I like real estate investing so much, and why I believe that real estate is a great wealth creator for everyone.
I imagine many of you have read articles (like this one) that talks all about how saving money and investing it wisely over a long period of time can generate large sums of cash. The conventional wisdom is that, if you start saving early enough in your life, you contribute periodically to that savings and you invest that savings into a safe, diversified portfolio (stocks, bonds, CDs, etc), you can retire at 65 very comfortably.
Not only does it sound great in theory, but if you do it right (start early, continually contribute, invest in a diversified portfolio), it really works! In 40 years, you can have a tremendous amount of money saved for retirement. There is a major downside to approaching wealth-building in this fashion: Time. In fact, time is a major downside in two ways:
- This style of wealth creation requires you to start at a very early age. If you don’t start early enough, you won’t have enough time for compound interest to work its magic and start to generate large sums of cash.
- This style of wealth creation requires decades to build the amount of wealth needed to attain financial freedom from a 9-5 job.
So, while saving, continually contributing and investing in diverse portfolio will certainly work for some people, it won’t work very well for those who aren’t young and/or those who don’t want to wait decades to attain financial freedom. Let’s take a look at an example that will demonstrate what I’m talking about.
Let’s look at three investors, aged 25, 35 and 45. All are saving for retirement. Each saves and invests $1,000 each each month and earns 8% annual returns on their investment — pretty typical of a diversified portfolio.
At age 65, the investor who started at age 25 will have over over $3,500,000. The investor who started at age 35 will have just over $1,500,000. The investor who waited until 45 to start investing will have under $600,000. Waiting 20 years to begin investing cost the investor nearly $3,000,000! In fact, only $240,000 of that would have come directly out of the investor’s pocket — over $2,650,000 of that is lost interest!
Starting just 10 years earlier can even make a significant difference. The investor who starts at the age of 35 will have two and a half times as much as the investor who starts at the age of 45. Clearly, the longer you invest/wait, the more money you have, but other than waiting, there is absolutely nothing you can do to influence the return on your investments. You have no control over how quickly you grow your money.
And again, for those who don’t have the time (are older) or don’t want to wait (looking for financial freedom sooner), this isn’t an optimal recipe for wealth creation.
But luckily for these two groups of folks, time doesn’t have to be the only factor when it comes to trying to achieve financial independence. When it comes to investing, there are actually two important variables that contribute to how much your money will grow. As we discussed, Time is the first. But the second is equally – if not more – important: Rate of Return.
Rate of Return
Again, if you read enough articles like the one above, you would think that the only rate of return you can get on your money is the 7-9% that you get from diversifying your money across lots of paper (stock market) assets. But, is it really the case that all your calculations should be based around the assumption that your investments will return 8%?
There are lots of investing strategies that return more or less than the much-quoted 7-9%. For example, savings accounts return around 1%, not enough to even keep up with inflation. Treasury Bills (T-Bills) and Certificates of Deposit (CDs) return about 3-4%. Obviously, those investments return less than typical stock market returns. Which is why many of us like to specialize our investing into a single niche area where our returns (and wealth accumulation) can be significantly higher?
How much higher? Let’s take a look…
What’s Does a Few % Really Mean
The difference between earning your 8% from a diversified portfolio and earning closer to 15-20% through real estate (rentals, flipping, lending, etc) is probably more than you realize. In fact, a couple percent compounded rate of return can make the difference between being able to retire in 40 years vs. being able to retire in 10 years. For a lot of older investors – and younger investors who don’t care for work – this is the key.
Let’s look at the difference in the growth of your money based on different returns…
Using the example situation above, let’s assume an investment amount of $1,000 per month. For a 25 year old who has 40 years to invest, remember that we can expect to earn about $3,500,000 by the time he turns 65 by investing into a diversified portfolio earning 8%. Now, what if that 25 year old were to receive 15% annual return compounded for the same 40 years…how much do you think he’d have? The answer is, more than $31,000,000! The difference between an 8% and a 15% return over 40 years was nearly thirty million dollars, or 10 times as much!
How about a 45 year-old that only had 20 years to save/invest? To have the same amount as the 25 year-old — who is earning the 8% from a diversified portfolio — when he turns 65, he’d need about a 20% return. If the 45 year-old can increase his investing return from 8% to 20%, he can cut the amount of time necessary to reach his retirement goal (or any financial goal) in half!
Here’s the main point — when you only consider the Time variable of investing, you miss a key element that defines your success as an investor. And that’s Rate of Return.
Why Real Estate?
So, now that you’re (hopefully) convinced that you’d much rather be making a higher rate of return than a lower one, let’s get back to the issue of how to make more than 7-9% on your money like you would with a diversified portfolio of stocks and bonds.
Is 15% achievable? How about 20%? More?
Yes, they’re all achievable. As a buy-and-hold investor, I’ve earned between 15-30% returns (leverage helps). As a rehabber/flipper, I’ve earned up to 45% returns on a relatively large portfolio in a single year. I know investors who have doubled their money (100% returns) in a single year. I even know plenty of part-time investors who can easily earn more than 15% returns on their investments without a tremendous amount of effort or time commitment.
It’s not easy. It requires focus, education, and experience; you must become an expert in your investment area. Sometimes it can take years. But that’s why the best investors are highly focused on one area of investing, as opposed to diversifying. They become great at what they do, and because they are so good at what they do, their returns far exceed the average, and far exceed what they would get if they were to just passively diversify their investments in stocks and bonds.