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| If only I could think of a good analogy for compound interest... |
A calculation which each and every person should
run (at least once a year) is to work out how much they need to be financially free. The problem is, the number this calculation spits out is often terrifying! You may be left wondering how on earth you will ever get to the
7 or 8 digits required?
This may lead you to end your quest for financial freedom
then and there, because the number seems more demotivating than
inspirational.
Fortunately there is!
And when you make use of the incredibly powerful weapon known as compound interest, it is possible to gun
down even the largest of numbers with the smallest of contributions – if you give it enough time.
Now, if you are reading this blog post, then chances are you are well versed in the awesomeness known as compound interest (it is one of the 4 P’s of successful investing after all). The problem is that human brains are wired to be linear, and this makes visualising the true power of something exponential (such as compound interest) kinda difficult. Heck, even those who are well aware of the power of compound interest are often still amazed at how quickly a calculators display can run out of digits when running long term projections.
Compound interest allows your money to multiply like….well…bunnies!
Given enough time, even just two bunnies can result in a hok which could cause a worldwide shortage of carrots. What happens is that the original bunnies start making more bunnies, and continue making more bunnies. But then the more bunnies also start making more bunnies of their own, and those more bunnies go on to make even more bunnies! I think you get the idea - you end up with a
The most important factor is not how many bunnies you start with, but how much time you give them – the longer you allow your bunnies to multiply (a.k.a. start now!) the more incredible the results.
Compound interest works in exactly the same way! And to help you realise just how much power your money bunnies have (especially if your time horizon is still long), I have put together an investment calculator. I am hoping it will dangle enough of a carrot to convince you that it is possible to reach all your financial goals - if you are willing to find the money to invest, and then give it enough time.
You can download the spreadsheet here, or hop on over to the Spreadsheets Page, where I have linked to it as well.
The Stealthy Wealth Compound Interest Calculator
Using the compound interest calculator is pretty straightforward, but probably best explained by way of an example.From the month that my son was born, I started investing R500 a month towards his Tertiary education. At the time, I estimated a 4 year degree to cost in the region of R120,000.
With this information, let’s use the calculator to work out if I will have enough to cover a University degree by the time he is 18.
The grey part of the spreadsheet is where you can type in all the inputs. Hovering over the cells will give more information about each one, but in short:
- Expected Return – Use this cell to specify the return you expect the investment to generate. This value will depend on which asset class you are investing in (get some values to guide you over here.) I used a slightly conservative return of 12%.
- Period – This is how many years the investment will run for. For this example, I assume my son will go to University when he is 18.
- Starting Balance – If you already have something invested towards your goal, then insert the value over here. Since this was a new investment for my son, I set this value to 0.
- Monthly Investment – This is how much you are putting toward the investment each month. As mentioned I started with R500 a month.
- Inflation – This is how much you expect the goal you are aiming for to inflate. If you are investing towards financial freedom, you can use your personal inflation rate, or CPI, or the South African long term average inflation rate. What is important is that you use a figure which is relevant to what you are investing toward. Since I was aiming to be able to pay for a Tertiary education, I used a figure which was around the average Tertiary Inflation rate, 9%.
- Increase Monthly Investment By Inflation? – Set this option according to whether or not you plan on increasing the monthly investment amount each year by the percentage specified in the inflation rate input. I selected yes, which means that every year I should up the monthly investment amount by 9%.
The calculator then spits out some numbers:
The "Own Money" value is a total of all the monthly contributions made. In other words this is the Rand value which was contributed to the investment.
"Investment Returns" is the Rand value which was generated from the compounded returns of the investment. Isn’t it incredible that the compounded returns is estimated to generate more than four and half times the money that I put in!
Out of interest I also included a "Returns Contribution To Final Investment Value" which is a percentage showing how much of the final investment amount is made up of compounded investment returns versus how much is from the money which was put in. In this scenario more than 62% of the final investment amount came from compounding returns - talk about bunnies getting busy!
The "Final Value" is the total Rand amount of the investment. It is basically the money contributed plus the returns generated. In this example, the investment would be worth over R630k by the time my son is 18.
Now it seems like the "Final Value" would be enough to cover a R120k degree more than 5 times over. Unfortunately this is not quite true. We must remember that over those 18 years that I would have been investing, the cost of a Tertiary Qualification would have been inflating by an estimated 9%. So we need to adjust the final investment amount to compensate for the increased cost of the degree. The last cell with the blue border "Inflation Adjusted Total" does just that – and I am left with an estimated R134k in today's University cost money.
So it seems I will be okay – if my inputs hold true.
The calculator also spits out some pretty pictures which are great at illustrating the immense benefit of compound interest over time.
This first one shows the final investment amount together with how much of that amount is made up of contributions versus the how much is made up of investment returns (click for a larger image).
As you can see, in the first few years, the investment value is made up almost entirely of my own contributions. But then after a few more years, the contributions start becoming a smaller part of the final investment amount, and more and more of value of the investment comes from compounding returns.
The progression of own contributions versus investment returns is shown in the final chart (click for a larger image)
After the first year, only 6% of the investment value comes
from returns. After 5 years, a quarter of the investment value is thanks to
compounded returns. Then, after 13 years, more than half the value of the investment is due to compounding returns, and finally, by the end of the period a full 62.5% of the
value of the investment has been courtesy of them bunnies!
Inflation - The Bunny Killer!
Something you may have been surprised by, is how the final Rand value of R632,000 vapourised into just R134k after adjusting for inflation. This is why inflation is called the silent killer, and, as you can see, it’s very harmful to your bunnies health!And that’s the problem with “investing” in a bank account – it won’t really grow your money. The return you get from a bank account is usually pretty much in line with inflation, so as your bunnies multiply, the older ones get killed off by inflation, and your bunny population stays the same. You don’t really move forward.
So, if you have a long time frame, you will likely be many times better off by investing in growth assets (such as equities or property), because the returns you can expect will outpace inflation. And so you end up growing your money in real terms.
Investing in growth assets is like dimming the lights, putting on some romantic music and lighting some candles for your money bunnies. You are going to see far better results!
In The Comments:
What are you investing toward?
Has the compound interest calculator given you hope that you will be able to achieve your goals?
Till next time, Stay Stealthy!
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