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Two Pillars For Building Wealth

October 9th, 2017

Long Term Focus

The most important and time tested secret of investing success which leads to building wealth is to keep the focus on the long term rather than short term.

In the short term markets can be very irrational and hence focusing on the short term unfortunately provides an opportunity for investors to commit many unintentional mistakes. Over the long term markets tend to go higher and the predominant reason for this is equities provide the best inflation adjusted returns.

But keeping the focus on the long term alone is not enough. Investors have to understand this long term focus is to be built on two important investment pillars.

Pillar 1 - Asset Allocation and Rebalancing

The first and most important pillar to building wealth is Asset Allocation. A well-structured asset allocation strategy has an excellent probability to outform other market timing strategies - according to many leading investment practitioners and research performed by risk management specialists.

While Asset Allocation is the output of a sound investment policy, investors should remember there are two important pillars which support the framework of successful asset allocation outcome.

After money is funded to a portfolio and asset allocation has been performed, an investor cannot afford to just let the portfolio go on auto-pilot mode for ever. While Market Timing has found to be not very successful, a self-directed investor must not forget to perform this one important action while managing his/her portfolio: Rebalancing.

Periodic Rebalancing of a portfolio is an essential task which can make a huge difference in determining a portfolio's performance. A portfolio that's not rebalanced at all will start looking very skewed after a few years when compared with the strategic asset allocation weights. This is often referred to as Portfolio Drifting and this can be detrimental to its performance.

Rebalancing not only helps avoid Portfolio Drifting but also sets the base for implementing automatic value investing principles in the portfolio if the rebalancing approach involves selling strength and buying weakness.

In order for a rebalanced portfolio to meet investor objectives over the long run in terms of building wealth, an investor should not overlook another important function: New Cash Infusion. Periodic/Systematic Cash Infusion to a portfolio at the same time a portfolio is rebalanced by rotating out of top performing asset class to underperforming asset class automatically enables more assets to be bought at lower prices which can boost portfolio returns over the long run.

Pillar 2 - Power of Compounding

The power of compounding cannot be underestimated as it works its magic over the long term, especially with additional capital infusion.

For example if an investor starts a portfolio with $10000/- which is rebalanced annually using the approach of rotating out of gainers into underperformers. This investor also adds additional money of $10000/- at the time of rebalancing and does this over a period of 25 years.

Without considering taxes, if the investments earn an annual 8% return compounded, the terminal pre-tax value of the portfolio is likely to be $662,574.65. That's an amazing growth rate!

Also important to note, the terminal portfolio value is likely to be just $68,484.75 if that same investor had not introduced new capital every year but only rebalanced.

As can be seen in this example, the difference is huge from the perspective of building wealth. The power of compounding works even better if capital is added to portfolio systematically over longer periods of time.

Investors who intend to build wealth should not overlook these two strong pillars of long term investing.

Good Luck and Safe Investing!