The Power of Compounding: How to Double Your Money Every 7 Years
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
Building wealth through investing comes from the power of compounding capital over time. Many people don’t get excited about a 10% annualized return, but that 10% doubles every seven years. That means an investment portfolio that generates a 10% annualized return will be worth eight times more in 21 years.
Yet how many investors can honestly say that they’ve increased their investment portfolio by a factor of eight over the last two decades?
To Tap the Power of Compounding, Invest in Assets with High Expected Returns
David Swensen, chief investment officer of Yale’s endowment, is considered by many to be the master of modern portfolio theory. Under his guidance, it has achieved a 12.6 percent average annual return over the last 20 years, beating the average 7.6 percent endowment return by more than 60% and substantially outperforming the traditional 60/40 stock and bond portfolio. His strategy relies heavily on allocating to alternative investments that have high-expected return characteristics such as venture capital, technology and private real estate. This formula is how Swensen managed to turn $4.9 billion into $25.4 billion.
Private real estate makes up about 13% of the portfolio today and has been a large contributor to its overall success. In fact, real estate has been a favorite asset class of many institutions and endowments because of its lack of correlation to public stocks, low volatility and high return characteristics. The asset class tends to behave like a hybrid between stocks and bonds, delivering both high yield cash flow and the potential for appreciation.
Swensen’s formula doesn’t apply to only endowments and institutions. Individuals can also enhance their portfolio’s performance through greater exposure to alternatives such as private real estate.
Watch Michael Episcope break down Dave Swensen’s investment strategy for Yale’s endowment.
At Origin, we enable individual investors to tap the benefits of this asset class through our funds. They are structured to allow investors to leverage the experience of our team and diversify their capital across more than a dozen deals. Our goal is to double our investments over a hold period of five to seven years, and we’ve exceeded our return goals in our first two funds in terms of the equity multiple and IRR.
Short Duration Funds are Key
Short duration funds last only five to seven years and can build greater wealth for our investment partners. That’s because we hold assets only until we’ve maximized value. This allows us to turn our capital twice in the same period that other fund managers turn it only once, and build substantially more investment value for our partners. It is a key to profitability; long-term success in private equity real estate investing, or any private equity investing, depends on keeping your capital working in assets with high expected returns at all times.
We invest our money side-by-side with investors, and we want our $10 million commitment to Fund III to be worth $100 million in 15 years or less. We believe the way to do that is by not holding assets longer than we should.
Committing to Multiple Funds Builds Greater Wealth
The key to smart investing is to make sure that capital is working at all times. Committing to subsequent funds is the best way to make sure this happens in private equity real estate. The advantage of layering funds on top of one another is that capital returned from one fund can be put to use right away in the next fund. Idle money sitting in a bank account can destroy returns.
Our partners who have done exactly this have been rewarded. For example, investors in Origin’s Fund I will receive more than twice their original investment in slightly less than five years once Fund I is fully liquidated. An investor who committed $250,000 to the fund will receive $550,000 in total proceeds (which includes their original investment).
Ninety-two percent of Fund I investors committed to Fund II, and almost all of them doubled or tripled their commitment level. And again, investors are on track to more than double their invested equity, but this time over a period of roughly six years. Rolling the $550,000 yield from Fund I into Fund II has generated an account value of $798,000 today. This sum equates to a more than three-fold increase in the value of the original $250,000 investment in less than five years.
More significantly, that $798,000 is on track to grow close to $1,100,000 over the next three years as we fully realized all of Fund II’s assets, which amounts to more than 4 times the original $250,000 investment.
10X on Money in 12 Years by Compounding Across 3 Funds
Let’s take this one step further. We fully deployed Fund II and have closed fundraising for Fund III at $150 million. The goal for Fund III is the same as Funds I and II: To double our capital over five-to-seven years by investing in high-quality, underperforming assets.
Assuming we achieve our objectives with Fund III, that $1.1 million investment will be worth $2.2 million in about five years from now. That’s nearly 10 times the value of the original investment of $250,000, and those returns will have been generated in less than 12 years. That’s the power of compounding and keeping money at work constantly.
Of course, there’s bound to be a market environment in the future that doesn’t produce the same returns that we’ve seen in the last six years. That doesn’t mean that investors should abandon private equity real estate altogether. In the long run, the outlook for this asset class is very strong and a good asset allocation strategy beats market ups-and-downs every time.
Instead, investors should decide how much of their portfolio to invest in private equity real estate and stick to that number through all market cycles. Investments don’t always make money in the short run, but they will over the long run. Even during the dire 2008 recession, top managers returned slightly more than 100% of invested capital to investors.
Preqin, the leading source of data in real estate investing, tracks the performance of private equity fund managers and ranked Origin’s Fund I and II in the top 10 percent for performance for their size and vintage. At Origin, the combination of our team, our strategy, our exceptional sourcing capabilities and our sound risk management policies is why we have outperformed other managers in our first two funds — and why we believe we will continue to outperform in all environments.
Alternative investments are an essential part of the modern portfolio. But to take advantage of them, it is important to seek asset classes that have high expected returns and spend time finding the best asset managers in that space. They should have a proven track record and invest significantly in their own investments. The best managers find a way to make money in all markets. Define your portfolio target allocations and stick to those allocations in every environment. Following a process will yield the greatest success.
Markets don’t move in a linear fashion and certainly don’t go up every year. Make sure that you have exposure at all times so that you do capture the good markets.