My comment: Moving a step further, if you can identify the best trends in the market, you can increase the value of 'R' in step-2. When one trend has reached its peak you move onto the next trend. Currently the best trends out there are Dry Bulk Shippers, Solars and Technology.
Motley Article follows:
The formula
It is, simply:
FV = PV * (1+r) ^ n
Where:
FV = future value
PV = present value
r = rate of return
n = time (or number of years)
Compounding 101
Now, some astute finance brains will know that equation not as some mystical secret but as the "future value of money" (FVM) equation taught in college.
The FVM formula simply states that your future wealth (FV) is a function of three variables: the amount of money invested today (PV), the rate of return generated (r), and the length of time in which that money is put to work (n). So maximizing future riches requires three steps.
Step 1: Increase PV
It takes money to make money. But by actively and consistently slivering off a portion of your earnings every month to save and invest, you'll have more and more of that money working for you.
All things equal, the greater amount you invest today (PV), the greater wealth you'll build for tomorrow (FV).
Step 2: Increase r
Next, you'll need a way to grow that capital. Historically, the stock market has been the most effective wealth-building vehicle of all. Plowing your money into a low-cost index fund wouldn't be a bad idea.
But if you really want to maximize r, you'll need to allocate a portion of your portfolio to the best segment of the market over the past 50 years: small-cap value stocks. The reason is simple. Unlike behemoths such as $115 billion Merck (NYSE: MRK) and $190 billion Johnson & Johnson (NYSE: JNJ) -- whose spectacular growth days are behind them -- reasonably priced small caps have tons of room to rocket.
All things equal, the greater your rate of return (r), the greater wealth you'll build for tomorrow (FV).
Step 3: Increase n
The last ingredient in our super-simple wealth building recipe: maximum time in the market.
Look back at the equation. You'll see that n is an exponential function -- meaning that for every year you're not invested, you give up the awesome (almost magical) benefits of compounding.
All things equal, the longer you're invested (n), the greater wealth you'll build for tomorrow (FV).
Plug and chug
To get a feel for the three-step process in action, let's go back in time to see what kind of wealth would have been generated had someone:
- Invested $40,000 in the stock market
- Started 10 years ago
- Divided the money among five stocks having: market caps less than $2 billion (to screen for small size), sales growth greater than 15% (to screen for above-average opportunities), and price-to-sales ratios of less than 1.5 (to screen for a good price).
Here's what it would look like:
| Company | Amount Invested | AverageCompounded | Total Value |
|---|---|---|---|
| Best Buy (NYSE: BBY) | $8,000 | 33.9% | $148,075 |
| FTI Consulting (NYSE: FCN) | $8,000 | 27.7% | $91,892 |
| Expeditors International of Washington (Nasdaq: EXPD) | $8,000 | 24.2% | $69,682 |
| Florida Rock Industries (NYSE: FRK) | $8,000 | 23.7% | $66,947 |
| Fossil (Nasdaq: FOSL) | $8,000 | 25.9% | $80,332 |
| Total amount invested (PV) | Avg. annual return | Total value of portfolio today (FV) | |
| $40,000 | 27.6% | $456,929 |
By having bought into five high-quality, reasonably priced companies while they were still babies, that $40,000 stake would be worth nearly $500,000 today.
Of course, you can always fiddle with the numbers to generate different levels of FV, but our objective should remain the same:
- Maximize PV by sticking to an investment plan.
- Maximize r by devoting a chunk of your portfolio to superior small caps at attractive prices.
- Maximize n by investing as soon as possible and for as long as possible.
The final Foolish variable
So don't waste another "n." Start plugging whopping returns into your own real-life wealth equation today.
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