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Compound Interest : An Investor’s Guide

21 Dec 2017 
SOURCE: Dr Wealth

"Time is money!"

 

You've probably heard this saying before.

 

But before you brush it aside again, did you know that you can really turn time into money?

 

"Compound interest" is your answer.

 

What is Compound Interest?

 

Compound Interest refers to the interest calculated on the sum of the initial principal and the accumulated interest.

 

It is also referred to as 'interest on interest' or 'future value of money'.

 

What Compound Interest Does To Your Investing Capital

Compound Interest An Investors Guide 

In short, your money can grow over time due to the interest earned.

 

If you have heard the phrase 'money grows money', that's fundamentally how compound interest works.

 

Still confused? No worries, we'll break it down for you below;

 

Many successful investors and the rich are tapping into compound interest to grow their wealth.

 

Compound Interest An Investors Guide

​It's a lot like the 'snowball effect'. 

You start off with a small fist sized snowball, as you continue to nurture your investments, your snowball grows gradually and starts building on itself. Soon, it gathers the momentum and becomes a powerful wealth building machine.

 

And that's what we all want as investors.

 

But how do we start the snowball?

 

Let's explore that question next;

 

3 ways to get Compound Interest working for you

 

Although it sounds complicating, it's actually quite easy to get compound interest to work in your favor. Here are 3 ways:

 

Bank Saving Accounts

 

Most saving accounts by the banks provide compound interest based on your balance. Some of them even reward you with higher interest if you were to park more money with them.

 

However, saving accounts are also known for providing extremely low interest.

 

It's compound interest nonetheless, but it will take a longer time period before you actually feel any growth in your wealth.

 

So, let's look at other options...

 

CPF

 

You would probably already know this. The government has volunteered to help us grow our money through the CPF.

 

CPF OA provides up to 3.5% interest p.a. while the CPF SA provides up to 5% p.a.

 

That alone beats many saving accounts' interests hands down.

 

The downside to placing your capital into your CPF is the lack of liquidity. You will not be able to withdraw your capital in your CPF until the age of 55.

 

As investors ourselves, we believe that we can get higher returns than the CPF, and enjoy greater liquidity if we manage our own capital. Hence the next option;

 

Stock investing


 

There are 2 ways to get 'compound interest' from your stock portfolio - capital gains and dividends (when reinvested).

 

We have been strong proponents of the STI ETF for the lazy or busy investor. 

 

Although its returns has been lacklustre over the past few years, it still provides a greater return compared to the CPF interest rates. And, it does provide a greater amount of liquidity too.

 

With that said, if you are more diligent and can spend a little more time analysing individual stocks (or even niche ETFs), you would probably want to beat the STI ETF's return.

 

Here's a quick look at what happens when you compound your wealth at different rates:

Compound Interest An Investors Guide  

*Assuming a starting capital of $10,000.

 

An Interesting Fact about 'Compound Interest'

 

Which also happens to be a pet peeve of ours...

 

You've probably heard of this quote

 

"The greatest invention of all time was compound interest."

 

Or even stumbled onto its other variations;

  • "Compound interest is the most powerful force in the universe."

  • "Compound interest is the eighth wonder of the world."

 

We argue that this is an urban legend and Einstein did not really say anything about compound interest, yet this quote is used so commonly nowadays. 

Here are the arguments:

From Mark Harrison,
"The earliest mention of this quote that anyone seems to have been able to find was a 1983 article in the New York Times. The only problem was that Einstein had died in 1955 – some 28 years earlier. So it seems most unlikely that the physicist ever uttered those words."
​From Ed Darrell,
"I wrote to the Albert Einstein Institute, to the American Institute of Physics, and to other places where people might know obscure sources of Einstein's sayings and writings, to try to verify the quote. It surely did not turn up in Bartlett's Familiar Quotations, nor in the Oxford Dictionary of Quotations. Those specialists in Einstein data and history could not verify the quote."


Now, let's stop using the quote! (or at least stop citing it as an Albert Einstein quote)


Ok, let's get back on track.


You would have realised that it isn't so difficult to get compound interest working in your favor now, isn't it?


But wait!

Before you even start ploughing all your capital into investing, there's 2 more things you'll need to know;


"How much can my money actually grow, and how long?"


You'll want to set a goal or a milestone before you actually start investing because then, you'll know how well you actually are doing.


So, here are:

2 ways to calculate how much your money can grow


#1 - Compound Interest Calculator

As mentioned above, compound interest is also referred to as the 'future value of money'.


So, one way to calculate compound interest is to calculate the future value of an investment.


This formula allows you to do so:

 

Where;
FV = Future Value
PV = Present Value
i = interest rate (Annual rate of return in % / 100)
n = no. of years

Example:


 If I invest $5,000 at an annual rate of return of 6% for 7 years,​

 


 

Oh, and you don't have to do it manually. There are many compound interest calculators available online. Here's one: Moneychimp's compound interest calculator 


It is simple to use, all you need to do is to input the 3 variables; principal, growth rate (aka the annual rate of return), and number of years:



#2 - Dollar Cost Averaging Calculator

This calculator is suitable for those who decide to invest regularly into the STI ETF (or any other vehicle that allows you to use Dollar Cost Averaging).


If you are investing in a periodic manner like Dollar Cost Averaging method, you can calculate the future value of your total investment using this formula:

 


Where;
FV = Future Value
PA = Principal Amount (initially)
AC = Annual Contribution
i = interest rate (Annual rate of return in % / 100)
n = no of years

Example:


 I am putting in $200/month ($2400/year) to invest in STI ETF. Assuming a conservative annual rate of return of 5% for 20 years, this is how much I'll accumulate:

 


Again, you do not need to do this complicated calculation manually. 

Just use Moneychimp's basic investment calculator.

Again, all you need to do is to input 4 variables; principal, annual contributions, growth rate, and number of years:



If you are still not convinced about compound interest, play around with the calculators above.


We believe that you will be convinced that you can indeed exploit the concept of compound interest to grow your money and wealth.


#1 investing myth that stalls compound interest

By now, most investors would be convinced that compound interest gives their portfolio wings~


 
But, most of them go ahead and stall the growth of their wealth by doing this .


Warren Buffett is the most successful investor of the century. He was a proponent of the 'buy and hold' investing method. 


The keyword being 'was'. 


And today, we'd like to warn you retail investors (yes, YOU) that:


Buy and hold is not as easy as you think!

Do note that we are not against the 'buy and hold' strategy. 


We believe it can really bring you great wealth – after all, Warren Buffett did employ this strategy in the past. And it did play a part in making him the world's richest investor today.


Also, many investors are familiar with this strategy and often practice it.


But, not many are successful.


 

4 Reasons Why Investors Fail To Maximise Compound Interest When They Buy And Hold Stocks

 


You should look out for these pitfalls in your own investing!



1) Failure to plan for future money needs

This boils down to personal finance.


Many people are myopic when it comes to money management. They only see the near future of 3 to 5 years ahead, and some may even see shorter than that. 


When it comes to investing, they foresee they do not need the money and are willing to part with their money and invest in stocks for the "long term", so as to grow their money. 


It is good that they are doing something for the future, but they might not have considered possible big purchases or major financial commitments that may arise several years down the road.



Some major financial commitment could include marriage or buying a house. Or, it could be a sudden need for cashflow in the case of a career change or retrenchment.


In order to free up some capital, they would usually choose to liquidate their stocks.


They would be very lucky if they can make a small profit.


The 'buy and hold' strategy is usually only profitable long term, safely to say 10 years and above.


Thus, it is important to know and plan for your potential money needs in the future before you invest with buy and hold strategy.

Do make sure you really do not need the money for any kind of events, either fortunate and unfortunate.



Set aside a sum of money before you invest so you do not need to liquidate prematurely.



2) Fear of Loss


As a 'buy and hold' strategist, you cannot afford to be affected emotionally by the ups and downs of daily stock movement.


Warren Buffett mentioned that he does not care if the stock exchange closes for 10 years!


Unsuccessful 'buy and hold' strategists tend to hold when losses are small, but when the losses sustain further, he or she may not have the tenacity to hold anymore and will liquidate the stocks.



Investors with weak psychology cannot endure the pain of holding when the chips are down.



During a downturn, a 50% reduction in their portfolio is normal, and how many investors would be able to handle the pain?



3) Lack of discipline and determination


As we mentioned previously, the 'buy and hold' strategy would most likely be profitable 10 years and above.


However, you may be able to buy near a market bottom and make a small gain when the market recovers in a year or two.


You would feel good about yourself and sell your holdings to realize the profits. The success ingredient in buy and hold strategy is time.


You have to understand the power of compound interest, where your profits will grow exponentially.


Your capital doubles, triples, quadruples, or even more...depending on the time horizon you are invested.


This is the edge that this strategy can give you.


With that said, if you have no patience for a good 10-20 years at the minimum, you basically lost the edge.


4) Lack of Business Acumen


In recent years, we have experienced tech companies taking over the S&P, overtaking traditional big companies like GE and Coke Cola.


In recent months, we have seen cryptocurrencies gaining traction, breaking new highs and being adopted over the world.


No one knows what is going to happen next month or next year . 


Industries are being disrupted at a faster pace today, compared to the old days when Warren Buffett practice 'buy and hold' solely.


Companies that do not innovate or stay relevant will not survive.


In that light, would it be easier for a part time retail investor with little to no business background to choose a company that lasts 3 years or a company that lasts 10 years?


We'd say the former is easier to succeed.


By implementing the 'buy and hold' strategy, you will need to make sure that most of your stock picks are 'right' for over 10 years.


And most of us just don't have the business acumen nor experience to make the right call consistently.


Even the professional analysts can't get it right all the time.


Hence, we would prefer to take on a slightly more active investing strategy where we aim to take profit from a stock between 3-5 years.


With the right strategy, you might do better simply because it's easier to pick companies that can do well in the shorter term. 


Conclusion

Notice how 3 out of the 4 reasons for failure listed above at 'internal' reasons that has to do with the investor's attitude and state of mind? 


Regardless of which of the method you plan to use to tap into compound interest, you will need to stay focused to your ultimate financial goal, and risk profile.


 

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