Archive | October, 2013

Property and the Compounding Effect

21 Oct

The third part of our series about the compounding effect on investments is property.

There is a saying that property prices double in value every 7 – 10 years.  This is often rubbished by so called experts but history speaks for itself.  We live on an island.  There is no new land being created and only so much building that can be done.  Population growth means house building cannot match demand so inevitably property prices will increase due to demand. Property is a great investment and one that over time continues to defy expectation and grows at an exponential rate. I’ve given some examples below to show the compounding effect on property values.

I often tell the story of my late step-father. We drove past a house that was for sale with an asking price of £269,000.  My step-father recalled how about 50 years earlier he had bought the house for £2000 and sold it for £4000 and thought he had done very well on the deal.  Doing the calculations the house had more than doubled every 10 years.

Friends of mine have just celebrated their 25th Wedding Anniversary.  They bought their house for £25,000 when they got married.  A couple of months ago the house opposite which is a two bedroom terraced house sold for £170,000.  Their bigger 3 bedroom semi-detached house must be worth at least £170,000 probably more. Despite the ups and downs of the housing market their property has on average more than doubled every 10 years.

When I started investing in rental property in 2000 a basic 3 bedroom house in my area was £35,000 today the same house is worth £100,000.  So although we have been through one of the worst recessions in history over 13 years the value of the properties has more than doubled.

Getting on the property ladder has proved difficult for some people trying to buy their first home, however, buy-to-let finance is still readily available with 15% – 25% deposit.  Buy the worst house in the street, renovate it and instantly the value of the house goes up.  The property can then be remortgaged.  The profit can be used to purchase another property.  As the values increase over time you can continue to remortgage and buy more houses.  Alternatively, you could sell one or two and pay off mortgages on other properties.

Imagine if you had been in my step-fathers position 50 years ago and bought several houses for £2000 what would your investment be worth today?

There was an article in the Daily Mail last week doing a comparison between how much house prices had increased since 1971 alongside food and wages.  If food and wages had gone up by the same rate as house prices you would today be paying £51 for a chicken and the average wage would be £88,000. Property continues to rise at an exponential rate.

All investments have cycles (refer to previous blogs) we seem to be at the start of the next upward cycle for property.  Where do you think house prices will go in the next 10 – 20 years? Is it time to start working on your property investment strategy?

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Compounding Dividends

9 Oct

Compounding Dividends is the second part of our look at the compounding effect on the four investment categories – Cash, Property, Shares and Business.

In the last blog we discussed a simple compounding strategy of investing £1000 every year and the effect of reinvesting the interest.  With our example over 37 years interest grows to the extent that while you have saved only £37,000 your total investment would be worth just over a million pound. We assumed a 14% growth rate.

Compounding Dividends uses the same principle of reinvesting.  This time we use the dividends and buy more shares which can produce exponential growth.  (Exponential Growth meaning the investment grows at a faster rate than allowed for using a simple compounding formula)

The strategy is the same as with the cash formula.  Invest a regular sum of money into high yield dividend shares then use the dividend to buy more shares.  The number of shares held each year increase as does the amount you receive in dividends. Repeat this process over and over and the exponential growth effect kicks in.  Example- Laura Ashley is a company whose shares trade around 25p and who pay a 1p dividend per share twice a year.  Investing £1000 would buy 4000 shares.  The dividend payable 4000 x 0.01p = £40.  This would buy another 160 shares.  When the second dividend was paid it would be calculated on 4160 shares so the next dividend would be £41.60.  Repeat this process and continue adding £1000 each year to your shares and it doesn’t take long to build up substantial dividends.  (Karen uses Laura Ashley only as an example and does not give any recommendations for buying or selling specific shares)

In his article Dividend Growth Compounding versus Interest Compounding, Ken Faulkenberry (Arbor Investment Planner) uses the example of making a one off investment of $100,000 into a 4% savings versus buying $100,000 worth of shares and reinvesting the dividends.

In his example after 50 years the total value of the cash investment is $710,668 but with the shares the total value could be $2,945,703.

Remember for any compounding strategy to be able to work effectively there needs to be plenty of time available along with plenty of patience from the investor to allow the compounding effect to work.  The younger you are when you start an investment plan the better your results will be.  This doesn’t mean someone in their 50’s or 60’s should start investing.  With life expectancy getting long and many people reaching 100 years of age there are still 40 to 50 years of investing available.

Karen is the author of several investment books including Surviving 2013 and Beginners Guide to Investing In Shares