On average, the stock market returns about 10 percent annually before inflation. While individual stocks can vary wildly, that beats the average returns against bonds or other asset classes. That’s especially true with annual interest rates back at zero percent.
But here’s the beauty of that average return: If you keep your profits in the stock market, you can grow your wealth far faster than even that 10 percent figure.
Why? Thanks to the power of compounding your initial investment, and with a few simple tools and strategies, you can optimize the compounding power of the stock market in your portfolio.
The Magic of Compounding
While a 10 percent annual return may suggest that it takes 10 years to double your wealth (10 percent times 10 years), the reality is that it doesn’t take as much time as it may sound.
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That’s because the 10 percent return isn’t simple interest that you’re pulling out of the market each year. The cash that gets reinvested into the stock market allows your returns to compound. And it’s the power of this compound interest that makes massive wealth creation possible over time.
That’s because of the rule of 72.
The rule of 72 is a basic rule of personal finance that shows the power of compounding your wealth when investing. You take the number 72 and divide it by your rate of return. That shows you how many years it takes to double your wealth in the stock market.
Using 10 percent as an example, 72/10 = 7.2, or just over 7 years to double your wealth, not 10.
Using an 8 percent return, which is closer to the expected rate of return for stocks after adjusting for inflation rates, your wealth still doubles in 72/8= 9 years, not 10.
But, let’s say you can earn a return that’s a big higher, say 12 percent, thanks to a focused investment on high-quality growth names in the market.
In that case, we divide 72 by 12, and find that we can double money in just six years.
And to double our money in the market in five years, an aggressive but certainly achievable financial goal, it takes an annual return of about 14.4 percent on our investments.
Other assets don’t even come close. High-yield bonds right now may return 3.5 percent, with the given interest rate near zero percent. The rule of 72 tells us that it will take over 20 years for that investment to double. In that time, most, if not all, of those profits could be lost to inflation!
What about real estate? It tends to appreciate at just 3 percent per year, hence why most real estate use leverage to boost their returns when investing there. But the unleveraged rate means that it will take a full 24 years for the asset to double!
With interest rates at zero in many savings accounts, or bank FD (fixed deposit), the rule of 72 shows that it’s mathematically impossible for that kind of return to double! No wonder investors and financial advisors are turning to stocks, or the riskiest bonds.
All it takes to earn this kind of wealth-compounding wealth is a solid investment option, and the patience to sit through the time it takes for compound interest to happen.
Ways to Double Your Money in Five Years
1) Focus on Growth
Within the stock market, some areas perform better than others over time. Looking beyond the daily volatility, it’s been clear in recent years that big tech names like Apple (AAPL) or Google (GOOG) have been massive drivers for the market’s overall return, making them a top investment locale.
It’s this focus on growth rate that can allow for massive returns that compound quickly relative to interest alone. For instance, Apple share rose nearly 50 percent in the first half of 2020 alone. And that includes a massive pullback in shares during the market crash in March!
Growth doesn’t have to come from the massive, trillion-dollar names in the stock market either. One of the top performers in the past few years are companies that are on the cusp of becoming household names like graphics card manufacturer Nvidia (NVDA) or software service Salesforce (CRM). It’s not the current price of these companies that matter, it’s the future value. It also helps that these fast-growth names usually have high levels of cash and low levels of debt, too.
When you focus your investing on high-growth companies, your overall annual returns will likely rise. The trade off? There will be some volatility along the way. But if you’re thinking in terms of how many years it can take to double your money, the higher volatility in the growth names are well worth it.
2) Improve Your Returns with Options
If you identify a stock that’s likely to have a massive return relative to the stock market in the next year, a better strategy for improving your returns would be to buy a call option instead of shares.
The beauty of call options is that they allow an investor to control 100 shares of a stock for each contract, but often cost the price of a handful of shares. As long as the stock moves higher before the option expires, the percentage returns can be fantastic.
A call option can turn a 10 percent move in a stock in the space of a month into a 50 percent gain, or higher, depending on how you structure the trade. That’s better than sitting on shares, let alone keeping your cash in the bank collecting barely any interest!
While options have this tremendous upside potential, they do run the danger of expiring worthless if the stock underlying the option trade doesn’t move high enough or fast enough. However, even a total loss on a call option trade can be less than a partial loss compared to owning shares of a stock that decline, so the overall risk is relatively minimal.
Nevertheless, putting a part of your portfolio into call options instead of shares, particularly with growth stocks likely to move higher, can substantially improve your portfolio’s total return and lower the number of years it will take to double your wealth.
3) Improve Your Stock Returns with Options
Options can also be used to help boost your returns in stocks you already own. How? Instead of buying options, in this case an investor can sell options.
Selling options comes in two flavors. For those who already own a stock, selling a call option against your shares, known as “selling covered calls,” can add to your returns with minimal risk.
A covered call adds a small little bit of income relative to an overall position, but structured correctly, an investor can avoid having their shares “called away” while conservatively adding another 10-15 percent per year.
The trick? This works better with the non-growth names in your portfolio that are unlikely to have any large rallies in the course of a year, like your blue-chip dividend stocks. That avoids the problem of being called away from your shares and having to put your wealth to work in a new position.
4) Avoid Losses
It may go without saying, but investors who avoid losses are more likely to see their gains produce exceptional wealth for them over time.
While avoiding losses entirely is impossible, investors who utilize a strategy like covered call writing can avoid losses on specific holdings during market downturns.
However, the easiest way to minimize losses on an investment risk is with the use of a stop loss. For any stock position, a stop loss limits the total loss, by setting a price at which a position is automatically sold.
Many investors may use a loss of 7 to 10 percent when originally getting into a trade. That limits the loss if shares start to drop.
As shares rise, an investor can raise the stop loss to higher and higher prices, a strategy known as a “trailing stop loss.”
Yes, in a big market selloff a stop loss may get triggered on a stock that eventually moves higher. So this strategy isn’t completely without its downsides. However, that’s better than watching a stock trend down, and swearing that you’ll sell it once it rallies a bit, and then never getting that rally!
5) Avoid Taxes and Fees
Part of a strong investment return is to avoid the “drag” that occurs from taxes and fees. That means investors looking to compound their wealth are likely to do a better job if they’re efficient in terms of taxes and fees.
Fortunately, since most online brokerage accounts have cut fees to zero, the fee issue isn’t a massive problem anymore. That also makes it cheaper to make more options trades than ever before as well. Just keep an eye out for things like an annual management fee or the like in your brokerage. It shouldn’t be too large, but you may be able to switch to a brokerage account with zero fees at all.
Taxes can be a different problem. The best way to avoid taxes is to use a tax-advantaged account, like a company 401(k) plan (or 403(b) plan if you work at a non-profit).
These plans limit what you can invest in to a handful of equity mutual funds or ETFs, but as long as you have some growth funds and use the lowest-fee fund managers available, you should be able to match the market’s long-term rate of return.
While that may not sound like beating the market, that wealth grows without having to pay taxes on it, which, depending on your specific income rate, actually results in a huge outperformance.
You can also use a self-directed tax-advantaged retirement account like an IRA or Roth IRA, which will also limit your tax obligations until you have to take money out in retirement. Either plan, even invested in a simple index fund, should handily outperform collecting interest in a bank account. So consider putting more wealth in stocks and just leave an emergency fund, hopefully one with a bank fixed deposit.
Finally, if all else fails, you can find stocks that are worth buying and holding as an investment indefinitely. If you don’t sell, you don’t have to pay income taxes. That can go a long way to help compound your wealth more quickly.
With just a few tools, any investor can easily set themselves up for higher rates of return on their investments each year. That compound interest can greatly reduce the amount of time it takes to double your wealth. The faster you’re doubling money, the faster you can hit your wealth and retirement goals and pad your nest egg.