Saturday, September 5, 2015

Power of Compound Interest

If you care to learn only one thing about investing, it should be the concept of compound interest. This is a core topic everyone should know about and is truly what got me excited about investing. I first learned about compounding when I read The Wealthy Barber at age 17 and it remains one of my top 3 most important investing concepts today. 

Compound interest is simply interest on top of interest. Let’s say you are earning a 5% return each year and started with $100. At the end of year 1, you would have $105. But at the end of year 2, you would have $110.25 – an extra quarter.  “A measly quarter!” you say? I know this might sound minuscule and boring but the effect of compounding builds exponentially over time to an enormous amount. 

Very few people I know understand just how powerful this effect really is. Someone who hasn’t been introduced to compounding may think that a 20% annual return will grow your portfolio about twice as much as a 10% return. This is completely wrong. Let’s take a look at what happens when $10,000 invested today grows at various return rates of 5%, 10%, 15% and 20%. 

At the end of 30 years, the portfolios growing at 5%, 10%, 15% and 20% were worth $43K, $174K, $662K and $2,378K, respectively. After 30 years, the 20% portfolio was 14 times larger than the 10% portfolio and after 40 years, it was 33 times larger.

Notice how just three things influence the portfolio value:
  1. Time horizon
  2. Rate of return
  3. Invested capital

As investors, we can become wealthy if we maximize our investment time horizon, rate of return and invested capital. It is easiest to do the first one – just start investing as early as possible. The effect of compounding isn’t really seen in the first 10 or even 20 years but after that – it builds rapidly. You may have heard that phrase “The best time to start investing was in your 20s. The second best time to start is today.” I couldn’t agree more.

The second factor – rate of return - requires significantly more work to maximize. It took me a lot of time and research to find a strategy that has the potential of generating double digit returns while managing risk (please refer to my performance page for more info). Lucky for you, this blog and the book Dual Momentum Investing should be able to accelerate the time needed for you to implement a sound & robust strategy. Keep in mind that a strategy isn't the only thing you need to ensure a high rate of return. You will need unwavering, ironclad discipline to stick to your strategy through thick and thin.

Invested capital is the third factor. 10 years ago I graduated from university with not a penny in my bank account, although thankfully I had no debt. Each year since then, I have been good at saving over 30% of my after-tax income and putting it into my investment strategy. It is highly important you put aside at least 10% of your monthly income for investing. A good way to implement this is by setting up a Pre-Authorized Chequing (PAC) plan that automatically funds your investments each month before you have a chance to spend that money. Forced savings can work wonders. 

In the chart above, the 20% return portfolio dwarfs all other portfolios. When plotting something growing exponentially over a long time frame, it helps to use a log scale on the vertical axis. In a log scale, each level on the scale is 10-times greater than the previous level. Below is the result. 

Now we can better see what’s happening in each portfolio. Look at the 15% portfolio - isn’t it amazing how a mere $10,000 can be turned into almost a million in 30 years?

Here’s a neat little rule when trying to think about compound interest in your head: The number of years it takes for your investment to double is roughly equal to 72 divided by your rate of return. So if you earn 20% per year, it takes only about 4 years for your money to double but if you earn just 5% per year, it will take about 14 years.

Since it's back to school week, I want to leave you with some homework: 

Download a financial calculator app on your phone. Type a few scenarios that meet your own personal criteria (initial investment amount, time frame, rate of return) and see what you can grow your portfolio to. Show this fun little experiment to your family & friends. Everyone I’ve ever shown this to immediately gets excited about investing. 

The app I like to use on my Android phone is called “Financial Calculators.” You can find it here. Below is a screenshot of the “TVM” (Time Value of Money) calculator included in this app. Enjoy