Compounding Leverage and Pyramiding Profits
Submitted 2011-09-20 13:30:02
If you could isolate one important similarity about all mechanical and electronic gadgets it would be that they are built to work. In fact if they don't work their utility is reduced to zero value. The lawn mower that never starts is referred to as a "hunk of junk" We are pointing out (with some irritation) that the object that is supposed to have a certain utility is devoid of that utility. It's a worthless pile of metal now in fact it's a liability taking up space in our garage. Any mechanical or electronic gadget or contraption that has no utility (it doesn't work) therefore loses its identity as a gadget.
Another word for gadget is tool or the more umbrella term a technology. A technology has usage full stop. No usage then its not a technology, its nothing. To go to the heart of this paradigm shift we realize that the metal screws and connecting parts aren't really necessary for a tool to have usage. Anything can be a tool, a technology as long as it has utility. If it can be employed to produce a result, it's a technology.
The net result of Opportunity Investment is a compounded profit. There are several tools we use when we exploit Opportunity Investment to achieve a result. Our goal is not a single profit. One transaction, a fortune, does not make.
We have an over all plan for the next month the next year the next 5 years.
The first technology any Opportunity Investment entrepreneur will visit is compounding. However some don't get passed it. It's a dangerous tool and you can get hurt playing with compounding.
Since the invention and mass production of the humble calculator more people have been hurt and hung up by compounding then at any time in history. (Obviously when we express "hurt" we mean set- back in our goals and aspirations)
The nature of compounding is greed. Numbers by themselves aren't greedy its what the human brings to this tool that can be detrimental.
Nevertheless compounding is a fundamental technology every single Opportunity Investor utilizes. Its used not only over long term projections compounding is used to micro manage projects on a day to day basis.
The first place one typically starts when using the compounding tool is at the ultra conservative end. We calculate how much money we will have at retirement if we deposit $40 per week in the bank, compounded at 7% annually over thirty years. You can work it out for your self if you are inclined by simply multiplying 40x52x1.05 and do the calculation 30 times on the last result.
However upon completing these calculations immediately we realize we may be too old to enjoy the money if we had to wait that long. We also note with some trepidation that over 30 years, inflation would travel at about 3-4% with us, so the purchasing power of that fund would not be too impressive. Take into account tax on interest and bank fees and the result, although initially exciting, is now not so good.
Clearly working for 30 years and saving is not the answer. But we persist, ok so lets double our savings plan how does $80 per week look? We feed the numbers into the equation and we aren't surprised, heck it's the nature of compounding, our result is double. Not good enough, so we keep playing with the compounding tool.
This is where it gets dangerous.
Casually amusing ourselves with our calculator, we suddenly get an idea. What if we could find a way in the real world to get a higher interest rate?
You get a twinkle in your eye as you hit the CE button excitedly three times to erase the previous calculations. You start with double the interest rate....14% You feel fairly confident you might be able to find a bank or co-op or some place that might have this amount of compounding on offer so you start again. $40 times 52 etc.
A tiny bit of drool starts to appear at the corners of your mouth as you get to year 25, wow, its getting pretty good, you hit year thirty and try 31 and year 32, wow, wow.
Of course what you do next is obvious, you double the interest rate again. 30% then 40%
You don't dare see it as anything but folly but you try the figures 100%, and 500%
You GET compounding now.
You have been toying with the calculator for a few hours now and tried every conceivable combination, you get it.
The ultimate Million dollar example.
You start with $100 dollars and ask yourself how many times you would need to double that initial $100 for it to grow into 1 million dollars. The answer is just over 13 times.
How long would it take to double the hundred? 1 month, so according to those stats, you could join the million dollar club in just over a year starting with 1 hundred dollars. Its possible. The planning would be huge. Nothing would be left to chance. But that doesn't happen. You are numbers focused and not plan focused. Indeed, commonly no particular strategy comes to mind.
What happens next is that you get hung up on the horn of the dilemma.
Desperate to initiate your compounding "wish" you choose the first investment vehicle that comes along that is remotely credible. The problem is you are blinded by the numbers and bubbling with optimism.
Many people get stuck on these numbers that the calculator spits out. They become fixated when they apply the numbers to their lives. They begin to "own" the numbers they begin to spend the profits before they actually earned them. In short, they lose their way.
The Correct use for compounding.
Compounding is an orientation tool. If used in this way compounding keeps you on track, in fact, if greed is resisted compounding will help you find the path best for you. The interesting news is that compounding at rates of 100%, 300% and 500% are possible even easy when you realize how. We talk about velocity of money, and ROI and ROE in upcoming titles.
Leverage, the sword of a Titan.
You may have heard of leverage being referred to as a double edged sword. If there was ever a good example of a technology or a tool it would be the sword. It's the ultimate tool for "getting your way".(just behind the pistol anyway)
Leverage is simply a term that refers to using OPM or "other peoples money". There are many types of leverage however the context most referred to is the use of money you don't own in exchange for a hiring fee usually paid in the form of an interest rate.
The caution many attach to leverage is unfounded. The expression "leverage is a double edged sword"
is really misleading. It represents a mysterious warning at best. What is meant by the expression is that as much as leverage has a capacity to assist you- that same capacity can cut into your progress if your result is a loss instead of a profit.
How it works.
A brief paragraph on how the sword of leverage fights for your good-.
A hundred dollars to invest will buy one widget worth $100. A typical Opportunity Investment deal will result in a profit of 30% or $30
Your return is 30% not bad if it only took a month to transact. (That's an annualized compounding rate of 360% 12x30%)
If you "leverage" that $100 by using it as a deposit for a loan. With a typical LVR of 80% Your maximum loan amount in this case would be $400 (+your 20% your $100) totaling $500
You may now purchase a higher quantity or quality widget for $500
On closing the deal you still make a 30% return. However now your profit is not $30 as in the example above 1.30% x $500=$650 so your profit is $150 so your return-on equity is not 30% anymore, even though you still spent the same $100 bill you started with your return is now 150% because you earned $150 and your investment was only $100 (the initial deposit on the loan)
Can you see how this can be exciting when you go back to your calculator? The compounding ramifications are staggering (150% annualized is 1800%). Of course there were loan costs and holding costs and taxes.
The reason leverage is considered a "double edged sword" is because in our example above if an Opportunity Investment deal went south and you bought $500 worth of value, a move of 10% against you would result in a $50 loss ( and that would translate into a 50% loss of your seed capital- think bigger numbers and you can see their concern)
However a 10% move against you with just your $100 spent on the investment object (without leverage) is the same 10% or $10. So the "curse" is that your gains are leveraged but so are your losses.
The problem we have with the caution is that its justified only in certain circumstances. For example a large company with a large operating leverage may find themselves in hot water if a relatively small error is compounded by leverage due to an unexpected drop in sales. This is a sales projection error and not related to singular well researched transactions. Also the caution ignores risk management strategies.
Ultimately we view it this way. We Invest to profit. Our discriminatory skills are a totally seperate issue to the question of leverage. If we dont use leverage and suffer 3 losses in a row then we are behind by the exact proportion that we would be if we did utilize leverage. Why? Because our gains that offset those losses were leveraged too. Or they weren't leveraged too. Either way the net result would be identical in proportion to either decision (to leverage or not) The difference is the net result would just transpire more rapidly which is why we use leverage in the first place.
To illustrate with an example. If you made 24 transactions in 12 months and 3 were losses. You would be a long way ahead with leverage. But if you did those same deals but you had 21 losses then leverage or not you would be behind.
We will talk more about this in the future, for now lets move on to the third and final piece of equipment-stacking cash.
Money is flat for a reason. When we were young we collected pocket change. It rattled around in the tin money box with delightful clanking noises. The money box felt heavy and the potential for ice creams and lollies was astounding. In this little tin box jingled countless possible trips to the toy store and corner shop. One day the can opener emancipated the coinage and the coinage was gone. What replaced it was match box cars and lolly bags. The decimated money box sat quietly on the shelf broken, opened and abandoned.
We learn very early that we don't want the coin we want the items the coin represents. We want true value. A bit of round steel with some writing on it is not the object of our desires. A paper note cant be eaten or lived in or slept on. A paper note is made to be stacked. They are so thin they can be stacked to bewildering numbers without taking up much space at all.
Without the capacity to delay gratification as an individual, you face returning to square one continually. Its practically impossible for a spend thrift to advance to a point where the working capital is finally plentiful enough to supply a living on top of profits. Its similar to trying to light a camp fire without matches. The kindling has to be so fine and so dry the conditions need to be just right and the nature of the endeavor is so very precarious until you see smoke, then a flame begins to lick, but if you let your guard down at that point, 9 times out of 10 you will be back at square one, and the fire will fail. Its not until a branch of decent thickness is alight that we can ad more "pressure" to the camp fire and be confident that the flames wont go out and then finally the larger logs are piled on for longevity.
This analogy serves to illustrate the same precarious circumstances you are in before the compounding has had a chance to work in conjunction with leverage. Without the commitment to delay gratification for a definite specific period of time the slow tedious work in the beginning will all be for naught.
Stacking your cash or pyramiding your profits is another form of focus to task. The splurges you may casually be used to will not be available until you are out of the woods. That's why we advocate strict segregation methods for your funds. Dipping in can be a big mistake and cost you years in terms of set backs. Bottom line for compounding and leverage to be effective ALL the profits must be re-invested into your next deal.
The three cog mechanism of Opportunity Investment. The three tools we present above are inter linking. They work, each relying upon the other to form momentum. If you are fortunate enough to be in the Million dollar club then passive income is easy. There is an array of choices out there in the 6-10% range meaning quite a comfortable income. For those that aren't, these three cogs align propel and steer toward that milestone goal.
Utilizing Opportunity Investment for financial progress is simpler with the right tools. When we want to build a deck on the back of our house the tools make the job easy and accurate. So it is with these tools.
Compounding is your compass its an orienteering tool. Without it like trying to find a place without a map, you will simply lose your way.
Leverage is the motorized time reclaiming device. It crams a year of compounding into a week. It is the drive in our momentum machine.
Pyramiding profits is the steering. Each deal takes you closer to the goal. Stop pyramiding profits and you veer off course away from where your compass tells you to go.
These three tools manufacture a singular result...progress to the next level.
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Article From opportunity-investor.com