Hi,
This is Vikaas here, Investment Advisor and Founder of www.jaagrav.com.
Today I am going to talk about which aspect of Compounding should you focus on?
While as a parent, I am asked a lot of questions!! Lots of them!! I came across a story, which was published in the New York Times on January 19, 1988: Isidor Rabi, the Nobel laureate in physics was once asked: “Why did you become a scientist, rather than a doctor or lawyer or businessman, like the other immigrant kids in your neighbourhood?”
”My mother made me a scientist without ever intending it. Every other Jewish mother in Brooklyn would ask her child after school: ‘So? Did you learn anything today? But not my mother. She always asked me a different question. ‘Izzy,’ she would say, ‘did you ask a good question today?” That difference – asking good questions – made me become a scientist!”
Importance of asking good questions, at times, even stupid ones, is all right. At least, it enables you to progress a little and remain curious. Just as knowledge compounds by reading, writing, and asking lots of questions, i.e. through vicarious learning, so does your wealth when it starts to compound. Bit by bit, gradually, it enables your hard-earned money to grow.
These were some of the questions which were asked by my son
#1. What’s the formula for Compound Interest?
#2. Isn’t it obvious that higher rate of return will lead to greater wealth creation?
Well, the formula for compound interest reads as: A = P (1+r) ^n
Where A = Amount at the end of n years and P refers to the Principal amount which would be invested at r% for n number of years. This answers the 1st question.
To answer the 2nd question, while most people focus on “r”, i.e. the rate at which your money is growing; however, it is far more important to focus on “n”, i.e. number of years at which the money will grow.
USD 1 million invested at 12% p.a. for 10 years translates to USD 3.10 million at the 10th year. However, USD 1 million invested at 6% p.a. for 20 years would translate to USD 3.20 million. Slashing the rate of return by 50% but elongating the number of years by 2x results in equal or greater amount of money at the end of the period. (USD 3.20 million Vs USD 3.10 million).
Similarly, USD 1 million growing at 3% p.a. (1/4th of the 12% p.a.) for the next 40 years (4x of the original period of 10 years) would translate to USD 3.26 million. Again, this amount, i.e. USD 3.26 million after 40 years Vs USD 3.10 million after 10 years is a tad higher!!!
So, compounding is more effective only when you focus on “n” more than “r”. Since, R, i.e., rate of return is partly dependent on you as an investor and partly on luck. Most of the times, you don’t know even now, how much of R is because of luck.
N, i.e. no. of years, however, is primarily dependent on you. So, greater the value of n, even if r is a little lower, you would achieve financial freedom if this were carried for a long period of time.
This is also where the art of maintenance or persistence comes into play. As Gaur Gopal Prabhu had said “Maintenance is most difficult! Creation and Destruction is easy”
It is equally important to ask whether high rate of return over long period of time ispossible to be earned by your investments or companies which are growing rapidly NOW!! The perception of high-growth companies, which trade at extremely high multiples thereby leading to higher r for investors, mostly unsustainable – how long would this last?
After all, one needs to be cognizant of the fact that it only takes a tiny hole to sink a ship and the perception to change from extremely fast growth loss-making companies to profitable sustainable cash flow generating companies.
Hope you enjoyed listening to this and would be asking some questions, after all, there are no stupid questions, only curious ones!!
For more interesting topics, you may check out my website, www.jaagrav.com. If you want to reach out to me, you may email me at vikas@jaagrav.com
Thanks!