Growing Wealth Through the Share-Market

The one thing that is severely under-communicated in respect of building wealth is the importance of starting young.

In fact, the three keys in my view are:

1. start young;
2. be consistent (I recommend 10% of after-tax income as a minimum); and
3. never touch the nest egg.

In order to demonstrate the power of starting young, investing consistently & leaving the investment untouched, I have created a ‘theoretical’ individual; let’s call him ‘Average Joe’. Average Joe is average in every way, most importantly for our examination, in earnings.

Average Joe Turned 20 on 1 January 1980. He immediately entered the workforce & immediately commenced earning the average wage (you may point out the unlikeliness of this – i.e. he would start earning less than the average wage and end his career earning a good measure more than the average wage). In any case, he immediately began setting aside 10% of his after tax income and has never touched his investment.

At present (for Calendar 2010), based on the Average Full-Time Adult Total Earnings from the Australian Bureau of Statistics, Average Joe earns $1,305.10 per week. He will earn $68,098.29 for the year and pay $13,979.49 in income tax (20.53%). I have used the mid-point from each year, you can check the ABS website for current and historic average wages - http://www.abs.gov.au/ausstats/abs@.nsf/mf/6302.0; it is pretty good for such information.

In his first full year of work (Calendar 1980), Joe earned $258.30 weekly, - $13,477.73 for the year. For simplicities sake, I have assumed he has always paid 20.53% of his gross wage in income tax (tax rates of course have changed frequently). So in calendar 1980, Joe saved $1071.08, with which he purchased an ASX200 index investment on the first trading day of 1981. Some said Joe was crazy, the ASX200 had advanced 48.86% in calendar 1980, and surely he was paying too much…

In calendar 2010, Joe will save $5,411.77, which he will invest on the first trading day of 2011.

Over the preceding 30 years, Joe has saved (and invested) $87,169.28. His current shareholding (bear in mind all he has ever done was buy the market with what he saved in the previous year on the first trading day – not at all strategic) is valued at $425,022.19.

In order to see how Joe might look come retirement age (which I will assume to be 67 by the time Joe retires in 16 years) we need to make some assumptions. I will assume Joe’s wages and the market move smoothly over the next 16 years at the same rate as they have done over the last 31, which I don’t think is unreasonable.

This being the case, when Joe retires on his 68^th birthday, on January 1, 2028, he will have earned $3,078,277.07 in his 47 year working life, or after tax have earned $2,446,306.78. He will have saved $244,630.68 (10% of his after tax income). The terminal value on retirement of his investment would be $3,789,336.58. That is fully 23.1% more than his gross earnings in his lifetime. Furthermore, it is 54.9% higher than his after-tax income.

These extrapolations are obviously just that, the average wage may not grow as quickly over the next 16 years as it has since 1980. The share-market may not achieve the same rate of return as the last 31 years. But Joe’s current results are impressive enough, and all he ever did was buy the market. It must be remembered that Joe’s investments are outside of whatever he has in superannuation as well. Average Joe will live well in retirement.

For those of you sceptical about projecting future returns, Average Joe’s Uncle, Average Joe Sr. commenced work at age 20 on January 1 1964 (earning the average 1964 wage of $51.70 per week), has earned the average wage all his life and will retire at age 67 on January 1 2011. He will have earned a total lifetime income before tax of - $1,261,141.11, after-tax income of $1,002,228.84. He will have saved $100,222.88, which he invested annually in arrears into the Australian Indices, without selecting specific stocks. As at today, 20 December 2010, Average Joe Sr. is worth $1,089,949.95, more than his total lifetime earnings. So you see my point (we don’t need ‘projections’ to make this look viable).

I appreciate there are many simplicities in this situation, for example, Average Joe Sr., would be earning something in the order of $40,000 in dividends annually, which would bring upon him additional tax obligations. This means, for example, instead of earning $68k in 2010, he would earn $108k. Instead of paying $14k tax, he would pay $27,910. When you factor in that his dividends historically in the ASX200 are franked at nearly 70% (about $12k in franking credits on $40k dividends), he is only out of pocket an extra $1,910. That’s a pretty small price to pay to retire a millionaire. The importance of starting young (point no.1) is demonstrated thusly – Average Joe Sr.’s first investment on January 1 1965 was $214.38, which as at right now is worth $40,540.23.

I will not post the next couple of weeks as I will be travelling (I anticipate January 17 being my next post), but I look forward to bringing you more of my ideas about wealth building in 2011, may it be a bright and prosperous one for us all - Tony Hansen 22/12/10