Thursday, November 21, 2013

Compound Interest


I love the concept of compound interest. I think I have mentioned before how I just find it so amazing, and so grossly underappreciated and undervalued. The older post is here.

I was never a firm believer of compound earnings myself, until I stumbled upon this study and chart. I was reminded by it by a recent post by InvestmentMoats, so I had no choice but to blog about this so that I can permanently remember about it.

Here is the magnificent table! It was from a study done in the US a while ago by Market Logic.


Now, compare investor A and B. The difference is digusting, and all it took was just merely time. This is under the assumption of $2000 annual contribution, and 10% interest rate. What a difference time makes!

I took the liberty of making a quick excel sheet example of my own, but perhaps in a more modern day context. I used $5000 annual contribution and a 5% interest rate, starting from age 25.

Why 25? Because guys have to serve in the army, that's why. Of course, if you're starting at 20, then the table will end at 50. The timeframe here is just 30 years. At 55 we also finally have access to our CPF money.

Why $5000 annual contribution? I think $5000 is definitely a realistic goal, as long as there aren't any extravagent purchases and you get a year-end bonus. $5000 is also a very realistic sum in the future to be able to squirrel away.

5% interest rates is considering how low rates are at the moment. Although historical returns have been about 6-8%, I think it would be better to be more conservative with our numbers. Hopefully, a well diversified portfolio can manage to get a 5% smoothed out return in the long run.

Investor A Investor B
Contribution Year end value Contribution Year end value
25 0.00 0.00 5,000.00 5,250.00
26 0.00 0.00 5,000.00 10,762.50
27 0.00 0.00 5,000.00 16,550.63
28 0.00 0.00 5,000.00 22,628.16
29 0.00 0.00 5,000.00 29,009.56
30 0.00 0.00 5,000.00 35,710.04
31 0.00 0.00 5,000.00 42,745.54
32 0.00 0.00 5,000.00 50,132.82
33 0.00 0.00 5,000.00 57,889.46
34 0.00 0.00 5,000.00 66,033.94
35 5,000.00 5,250.00 0.00 69,335.63
36 5,000.00 10,762.50 0.00 72,802.41
37 5,000.00 16,550.63 0.00 76,442.53
38 5,000.00 22,628.16 0.00 80,264.66
39 5,000.00 29,009.56 0.00 84,277.89
40 5,000.00 35,710.04 0.00 88,491.79
41 5,000.00 42,745.54 0.00 92,916.38
42 5,000.00 50,132.82 0.00 97,562.20
43 5,000.00 57,889.46 0.00 102,440.31
44 5,000.00 66,033.94 0.00 107,562.32
45 5,000.00 74,585.63 0.00 112,940.44
46 5,000.00 83,564.91 0.00 118,587.46
47 5,000.00 92,993.16 0.00 124,516.83
48 5,000.00 102,892.82 0.00 130,742.68
49 5,000.00 113,287.46 0.00 137,279.81
50 5,000.00 124,201.83 0.00 144,143.80
51 5,000.00 135,661.92 0.00 151,350.99
52 5,000.00 147,695.02 0.00 158,918.54
53 5,000.00 160,329.77 0.00 166,864.47
54 5,000.00 173,596.26 0.00 175,207.69
55 5,000.00 187,526.07 0.00 183,968.07

So, what do my results show? Simple. If you invested from 25-35 and only made $5000 contributions yearly, with a total capital outlay of $50,000, it would have turned into $184k when you're 55.

Alternatively, if you hadn't saved a penny until you were 35, and then started actively saving in a similar fashion, with a capital outlay of $100,000, it would turn into $187k when you're 55.

The difference in final value is small, but the capital outlay is huge! If you don't believe me, I invite you to make yourself a simple spreadsheet as well, and fudge around with the numbers.

When I first started my portfolio, I was under the impression that I would be receiving dividends occassionally from some of the funds that I purchased which gave out distributions. I would be able to accumulate the bits, research into which fund looks to be the best to top up, and it would be a odd form of value investing combined with reinvesting dividends.

However, I was quite sorry to find out that my platform actually does not pay out dividends. It instead immediately converts the payout to additional fund units. I was initially put off by this, until I read a few posts by the Monevator and decided that this method will work the best for me. Not only does it efficiently compound returns, it also never gives me the choice of not reinvesting my dividends!

After seeing such a compelling table above (either the study or mine), don't you feel massively motivated to at least start saving early and start compounding interest? I am reinvigorated! 

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