Intuitively, we (should) know our investments will grow over time by following a few simple investment rules: Investing in a diversified pool of assets, having a fair amount of our investment allocation to stocks (“growth” or “risky” assets) in the portfolio, and maintaining a disciplined investment approach through time, meaning invest regularly and not deviating from the master investment plan when things are getting tough. That’s a sure way of accumulating some wealth over time, but obviously, in the market place there are many (often fake) promises to deliver more wealth in quick time by following a certain strategy or investment guru, but none is guaranteed to yield the same or better results than the aforesaid strategy.
But what is thought perhaps less of, why does your investment grow over time and exactly what determines by how much it will grow? Simply speaking, total return in a portfolio over a specific period is made up by the growth in the portfolio values (final value less starting value) plus any cash distributions received over that period. Companies generally will grow their profits and dividends over time, therefore companies will become more worth over time (prices will increase), and when dividends and distributions are paid out and re-invested, more shares or investment units will be bought, thus making your investment more valuable over time – thus we have price growth, cash distributions and re-investment as the three role players or components of wealth creation over time.
Also, I’m interested in finding out how much does each component relatively contribute in wealth creation over time. For example, at year 10 of my investment plan, how much of my investment growth could be attributed to the price growth of assets held in my portfolio, or the distributions and re-investment of distributions buying more investment units? The same for year 20, 30, 40, i.e. does the relationship hold or does it change with the passing of successive investment periods?
Moreover, investors could follow different styles/approaches in achieving favourable investment outcomes. One group of investors could follow a strategy of identifying assets that are deemed good investment value with an expectation that those assets will re-rate in a next period because of more favourable market conditions or company-specific reasons. Alternatively, investors will identify assets that are expected to dominate their specific markets, whether frontier, emerging or developed, and keep on growing their profits faster than the rest, hence their prices should be going up more rapidly than their peers. Or, another group of investors will focus on assets that are yielding reliable profits and dividends over time, thus banking on those income streams to re-invest those distributions and therefore grow valuations over time.
Broadly speaking, we could identify two types of investment approaches, namely one that focuses/relying primarily on price growth (capital growth) of assets and another on the income abilities of the assets. Even though the difference in approaches may be perceived as subtle, it may, however, yield very different results, as well as the predictability/reliability of achieving certain investment outcomes over time.
This article will investigate each approach and the relative contribution of each return component (price growth, cash distributions and re-investment) in the wealth creation process over time, and while not necessarily judging the merits of the different investment approaches, provide an informative overview to the reader.