By Peter Freeman, Money Magazine
No, its not alchemy, but with these two strategies you could be on the way to turning $1000 into $10,000
It is often said that it takes money to make money, and that the more you have the more you are likely to make. What many people don’t realise is that you can launch yourself on the path to financial success even if the amount you have is really quite small.
Just $1000, handled well, can be turned into a much larger amount. And having done this you then will be in a good position to build even more wealth.
The trouble is, most people never even start down the path of wealth creation, or do so much later than they should.
"Many people delay investing because they think they don't have enough to make it worthwhile," says Peter van der Westhuyzen, head of marketing with Macquarie Bank’s margin lending division.
“This is a mistake, since you don't need a lot to take advantage of two of the main wealth creation weapons gearing and the power of compounding.”
By making use of both you can turn $1000 into $10,000 very quickly but only if you are prepared to accept a lot of risk. In most cases the more risk averse you are, the longer it will take to reach the $10,000 goal. Not surprisingly, the goal takes a very long time to achieve if you don’t borrow and instead invest your $1000 in very safe securities, such as bank term deposits.
Money magazine asked Macquarie and Midwinter Financial Services to suggest contrasting investment strategies that might enable someone with $1000 to turn it into $10,000.
"The earlier you start investing, the greater your chance of becoming wealthy," says Matthew Esler of Midwinter. His main recommendation is to use a margin loan to borrow to invest in an internally geared share fund.
"This sort of borrowing can be very effective but it is risky," he cautions, adding that it is essential to be able to leave your money invested for the long term to give yourself time to recover should you be hit by a major downturn.
Not surprisingly, CMC's strategy centres on using contracts for difference, an approach it admits is very high risk.
Independent expert Catherine Davey, author of Making Money from CFD Trading, says that, handled sensibly, CFDs can deliver great returns. "If you have the right mindset, and can stay calm, then trading CFDs can be a very powerful way to build wealth," she says.
What follows is two different strategies for turning $1000 into $10,000.
Which one suits you will depend on your appetite for risk and the extent to which you can afford to lose your initial $1000 should things go wrong.
Very safe but very slow
Macquarie Bank is associated mainly with innovative investments but it also offers a range of "vanilla" products. One of these is bank term deposits.
As van der Westhuyzen explains, Macquarie's clients normally use these as a place to park money that will soon be invested in assets that offer the possibility of much higher after-tax returns than those paid on term deposits.
"A lot of investors have adopted this approach recently due to the volatility of the sharemarket," he says.
However, a very conservative investor could use terms deposits as the base of a long-term wealth creation strategy a very long-term strategy.
In the case of someone with $1000 Macquarie calculates that it would take a staggering 45 years to turn it into $10,000 (after tax).
This calculation assumes the investor rolls over his or her 12-month term deposit each year into an identical deposit paying 7.7%. Interest is paid annually and is taxed at a marginal tax rate of 31.5%.
Of course, the situation is even worse than this since inflation means the real purchasing power of the $10,000 is much less.
In fact, assuming inflation of 3% a year the $10,000 is really worth just under $7500 in today's purchasing power.
Van der Westhuyzen points out that the actual 7.7% long-term return is not all that bad. The real drawback of this strategy is the fact that you pay your full marginal tax rate on each year’s earnings, leaving you with a much smaller amount to roll over into the new term deposit.
In contrast, investments that focus on earning capital gains are not only able to defer paying tax until the investment is eventually sold but, in most cases, benefit from the fact only half of it is taxed at your marginal tax rate.
Conclusion: This is NOT the way to turn $1000 into $10,000. While it is very low risk it also delivers a very poor return.
Unfortunately, many people do even worse since they simply leave their money in a low-interest rate bank account. If you want to build wealth you must shake off this sort of inertia.
Go for growth
It doesn't take a lot of money to invest well. Even a few hundred dollars is enough to start building a portfolio of shares.
With just a bit more you can invest in a number of managed share funds. Certainly anyone with $1000 will have plenty of choice.
By doing this you shift your focus from high-tax, low-growth investments, such as term deposits, to those that are highly tax effective.
Esler of Midwinter points that, in the case of shares and managed funds, you not only benefit from dividend imputation, which cuts the tax on the income the shares pay, but also from the 50% tax discount that applies to capital gains.
"Investing for long-term capital growth is usually very tax effective," he says.
A relatively conservative growth strategy would involve putting your $1000 in a share fund and leaving it there.
Esler crunched the numbers on this strategy, assuming a marginal tax rate of 31.5% and the returns generated by the Colonial First State Australian Core Share Fund over the five years to last September.
Someone who adopted this approach would have reached the $10,000 goal in real, after-tax terms after 14 years. This is a good result and reflects the fact this fund generated annual growth of 8.71% over the chosen five-year period and annual income of 13.23%.
Remember, however, that past returns are no guarantee of the future, especially given the current uncertain outlook for share prices.
More aggressive investors go one step further and combine sharemarket investing with cautious gearing into managed funds.
By doing this you can increase your potential long-term gains without taking on excessive risk.
One option is to make use of Macquarie Bank's Investment Multiplier an investment package that incorporates a margin loan that doesn't carry the risk of being hit with margin calls.
"This is important for anyone who doesn’t have much money to invest," says van der Westhuyzen. "If the value of your investments falls and you can’t pay a margin call you will have to sell, which is likely to result in a loss. Those starting out with $1000 should stick with a loan that doesn't carry this risk."
Based on a range of fairly conservative assumptions, Macquarie calculated that it would take just on 11 years for an investor to turn $1000 into $10,000.
Van der Westhuyzen says that this is a good outcome, but stresses that it overstates the gains since the $10,000 is before tax and the repayment of the margin loan.
"We prefer to look at pre-tax outcomes since it is often possible to time things so that you minimise capital gains tax," he says.
One example is when a young investor takes a year off from work to go travelling. Taking a gain at this time is likely to mean it is tax-free. The same can apply to someone who stops work to have children.
In making its calculations Macquarie assumed a margin loan of $3000 carrying an interest rate of 9.5%, 5% annual capital growth and 4% annual income (70% franked).
"The assumed returns appear conservative in the light of the big gains made from shares in recent years, but they are in line with the average returns achieved over the last 30 years or so," says van der Westhuyzen.
Conclusion: Gearing into a share fund is a widely accepted strategy that depends for its success on the returns generated by the underlying managed funds and the rate charged on the loan. Those who want to take less risk should consider using their $1000 to buy units in fund without adding on gearing.
For the complete story see Money Magazine's February 2008 issue. Subscribe now.
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