Sunday 14 January 2024

Wealth Accumulation 'boiling point'

The Money Guys posted an interesting youtube video outlining what they call the 'boiling point' of an investment portfolio. The essential concept is that at some point in your wealth accumulation and investment journey the amount you save and invest will stop being the main driver of your wealth accumulation, and instead the returns (reinvested) provided by your existing investment portfolio will be doing more to build up your wealth (NW) than the 'sweat of your brow' (savings from your salary income).

For example, if your annual income was $60K and you saved 20%, your savings would be adding $1K to your NW each month. And when starting out your 'portfolio' would be very small and investment returns modest in absolute terms, so the main driver of your wealth accumulation is your salary and savings rate, rather than the rate of investment return.

But at some point your investment portfolio would have grown enough that the investment returns being reinvested are the same magnitude as your additional savings. eg. If your portfolio was worth $200K and made a 6% real return, your NW would have grown by twice the amount you are adding via savings from your $60K salary, so your investment portfolio is 'working' as hard as you are to build up your wealth. This is what the Money Guys call the investment portfolio "boiling point". I tend to view this as "critical mass" where the wealth accumulation process has 'gone critical' and become self-sustaining (like in nuclear fission).

At some stage your portfolio might grow sufficiently large than the portfolio return is the major contributor to your wealth accumulation, and how much of your salary income you save each month is basically a 'rounding error' ( or a minor boost to your overall rate of NW increase).

I did a quick plot of my monthly NW changes for the past 20 or so years (excluding a couple of months where there was a major jump in NW due to being 'gifted' a property, or where I did a real estate revaluation for a period of several years in one particular month. I also did a 7-mo moving average of the monthly NW changes (to smooth out the random monthly changes a bit and highlight the overall increase in typical monthly NW change over time) and added in a linear trend line.

This chart clearly illustrates the concept - when I was starting out, my monthly saving accounted for most of the monthly increase in my NW. So how much of my after tax salary I was saving (plus the pre-tax SGL and salary sacrifice) was the major determining factor in how quickly I could build up some wealth. But after a decade or so the average monthly change in NW was equivalent to my entire salary, so even at a 20% pre-tax savings rate my savings were only contributing about 1/5th of my overall monthly wealth accumulation. And these days my NW increases by about 2x my pre-tax salary (or about 3x my after-tax wage income), so my existing investment portfolio is the major source of wealth increase, and how much I save out of my salary is largely irrelevant (eg. saving 10% or 20% might only be the equivalent of adding 0.1% or 0.2% to my investment portfolio rate of return). From here on (barring any market crash slashing my investment portfolio value) the main benefit of my salary is to provide my required spending budget without having to siphon off part of my investment portfolio growth. Hopefully by the time I retire even drawing down my required retirement income stream from my investment portfolio will have a negligible impact on my rate of wealth accumulation. 

ps. The scatter in monthly NW changes, and even in the 7-mo moving average, highlights when investing has to be approached with a long term outlook. While it is a lot of fun to see your NW go up by your annual salary in a single month, it is not quite as enjoyable to see an entire year's salary disappear from your NW in one month! Taking the 'long view' helps you remain sanguine about such market gyrations, and stick with your long term asset allocation strategy.

pps. It also illustrates why you might want to move slightly more conservative with your investment asset allocation (at least with the part that is funding your retirement) as you get older and your NW increases. At some point increasing the rate of monthly NW increase becomes less important than reducing volatility of returns. You would be happy to see the rate of monthly NW increase plateau if instead the volatility (and number of negative NW changes over a year) was diminished. But you can really only afford to trade off returns for reduced volatility once your NW has grown to a sufficient level. If you go too conservative too soon, then your investment portfolio might never achieve 'boiling point'.

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1 comment:

mOOm said...

Interesting. I've done a follow up post: