More than once you have been offered to invest in something that will change your life forever. There are no magic recipes in the markets, but there is a secret that will lead you to increase your capital until you can live off the dividends it generates.
More than once someone will have offered you “the business of your life”, “the investment that will make you rich in the blink of an eye”.
If you are interested in investments and you are starting to take your first steps in this world, you know that there are thousands of people suggesting or looking for an investment that saves them, that changes their future forever.
We are all looking to make more money and by our human nature we hear promises and longingly seek and hope to find that magic investment, strategy or portfolio that will make us rich. The Holy Grail, as many call it.
The search for the holy grail or that magic bullet happens in every possible field and in the world of investments as well.
I’m sure more than one person has also told you that this magic bullet doesn’t exist, and that the holy grail of investing is a delusion.
In this they are absolutely right. No investment magically solves our financial problems.
However, the Holy Grail in financial matters exists. What happens is that it is not a magic investment.
To find it, you have to look differently, you don’t have to focus on the investments themselves, you have to evaluate the characteristics of the investments and understand where this magic solution can really be found.
When reviewing and evaluating investments, the vast majority of people focus on the positives such as profitability, growth, tax benefits, etc., etc. But they leave out their most relevant aspects: those relating to risk management. And it is here, in risk and portfolio management methodologies, that we will find what we could truly consider the holy grail of investing, compound capitalization.
But what is compound capitalization? Perhaps the easiest way to explain it would be to say that it is about letting our profits generate more profits.
That is, the profits generated are not withdrawn from the investment, but we actively reinvest them, within the framework of the initial capital, so that it increases and that each time we manage and receive benefits of greater capital.
Compound capitalization to maximize returns
To understand the advantages of capitalization, we will use an example whose conditions we will exaggerate in order to make it clearer.
In this way, we can see the difference in profitability generated after making 100 operations or investments, whether or not we use compound capitalization.
Without going into the details of all the transactions, you can easily see that the size of the money risking on each transaction, where it says “risk” in the left column, is increasing. Instead, in the right one, it will always be static at 200.
Does that mean the left column is more risky or does it take more risk?
NOPE! In both cases we assume the same percentage of risk, what happens is that in the left one we add the profits to the capital and in this way we have more and more money to perform the operations.
The profitability gap at the end of the year is therefore 4756% against 400%! Compound capital 485,625 versus 49,600. This is the snowball effect of compound compounding.
The differences and the conclusions that we can draw from all this are very obvious. However, this type of exercise must lead us to consider something very important when making investments: we must try to differentiate at least 2 stages in our investment exercise: growth stage and income generation stage.
The first refers to the stage in which we must dedicate ourselves to making the account grow, a period in which we must reinvest our profits so that our capital grows. And when we consider that it has a large size, then let’s move on to the stage of generating income.
This second stage of income generation is where we will withdraw the profits generated by our capital, since we have managed to accumulate significant money, which allows us to make the profits representative.
See you in the next column.
Andres Moreno Jaramillo
For The daily investor
Colombian economist, trader, financial adviser and economic and stock market analyst. Master in Banking, Financial Markets and Wealth Management from the University of Barcelona and EAE Business School in Madrid. He has 20 years of experience in the financial industry, 18 of which as a stock trader and adviser.
He currently promotes development and investment in capital markets, gives lectures, lectures, courses and seminars on investments, personal finance and financial planning.