Tuesday, June 21, 2011

Power of Compound Interest "Thinking outside the Box"



 
"The best place to hide anything from a Black man is inside a book. We hate reading " Malcolm X".

By Sam Esale


This Essay is not for everyone. It is intended only for those who love to read for pleasure or for information gathering, and for whom length of material is not an issue. If you are looking for gossip or tabloid journalism, there is a plethora of that elsewhere. What you will find here is not ubiquitous.

Those of you who attended primary school in Africa will agree with me that any discussion on "Interest Rate", does invariably bring about memories in Arithmetic or some of the teachers you either liked or disliked and your childhood friends. Some of you loved Arithmetic, but most of us didn't. However, anyone who has received a student loan or bought or financed a house, an automobile or an electrical appliance or any other kind of consumer durables, in USA, is familiar with the concept of "Interest Rate", which could be translated to mean the cost of using Other People's Money (OPM). Interest on MONEY borrowed or invested can be calculated in one of two ways:

a) Simple Interest or APR.

b) Compound Interest.



Since almost everyone understands how to calculate "Simple Interest", this discussion will be limited to the calculation of "Compound Interest". The reason this is so important is because a basic understanding of Compound Interest, as applied to any financial instrument or money, will from this day, alter your perception of how money works, and although this information is publicly available, very few people pay much attention to it.

Any time you sit across the desk from your Financial Adviser at say, Bank of America or Charles Schwab or any Savings and Loans or Investment bank and you hear the expression "compounding annually", just remember that he/she is referring to Compound Interest. This expression is commonly used when referring to investment vehicles or financial instruments, such as Certificates of Deposits (CD), Bonds (Municipal or Federal Gov), Mutual Funds, Stocks, Derivatives or Commodities, etc. These instruments yield interest over time, and such interest compounds periodically, short term or long term. Understanding the power of Compound interest is mind boggling. So please, pay close attention. The following is the simplest way to calculate Compound Interest;


What is the Rule of 72?


If you divide the number seventy two (72 ) by your interest rate (x%), on any financial instrument or investment vehicle, the result will be the number of years (y) it would take for your money($) to double (x2). Sounds easy? This formula is known as "The RULE OF 72", in Banking or Financial Service industry lingo. It is a "universal rule".

Proof;

Let’s say Mr. Nyamangoro has a disposable income of $400.00 to either save or invest and he decides to deposit his money in a Savings Account with Bank of America (BOA) at 3% interest rate. Based on the formula above, if he divides 72 by 3%, the result will be 24. That means Mr. Nyamangoro's $400.00 will double every 24 years if he does not withdraw it sooner. So, If Mr. Nyamangoro was 40 years old when he opened the Savings Account with BOA @3%, he will be 64 years old before his initial deposit of $400.00 doubles to yield the result of $800.00.

On the other hand, lets say Dr. Porcupine, decided he was going to invest his $400.00 rather than just save it at the same bank. He then opts for a Mutual Fund Account, as an investment vehicle for his retirement. Assume for a moment that the "rate of return" or interest rate here is 10%. Using the same formula, Dr. Porcupine's money will double every 7.2 years,( i.e. 72 divided by 10% equals 7.2). Pretend that Dr. Porcupine was also 40years old when he initiated the investment. At age 47.2 Dr. Porcupine's $400.00 will double to $800.00, ( 7.2 years later), then at age 54.4 ( another 7.2years or 14.4 yrs later), he will have $1600.00 and then at age 61.6 ( 21.6 yrs later), his account will earn $3,200.00. Notice how Dr. Porcupine's initial $400.00 doubled three times in a shorter period, age 61.6, than Mr. Nyamangoro's, whose $400.00 doubled only ones at age 64.

Now, here comes Mr. Frutambo who is much more aggressive and more risk tolerant at age 40, and decides to aim for a higher interest rate thus going for "Stock Options", instead of a Mutual fund, and assuming that the "Preferred Stock" he picked was slated to yield 18% interest rate or rate of return on investment. In this case, and using the same formula as in Rule of 72, Mr. Frutambo's initial investment of $400.00 will double every 4 years.( 72 divided by 18%=4).Meaning that at age 64, Mr. Frutambo's account will earn $25,600.00.

Notice how the same amount of initial investment ($400.00) in three different kinds of accounts ( Savings = Mr. Nyamangoro; Mutual Fund=Dr. Porcupine and Stocks=Mr. Frutambo ), yielding different interest rates (3%, 10% and 18%), end up with completely different results ($800.00; $3,200.00; $25,600.00 ),over about the same amount of time (age 64, age 61.6 and age 64). That is the Power of Compound Interest.

So, knowing what you now know, please, answer the following questions;

1) Where would you rather have your money and why?

2) Why is everyone not maximizing the return on their investment by seeking the highest rate of return or interest rate possible?



RISK vs. REWARD.



Mr. Nyamangoro may have preferred the Savings Account option because it involves less risk = "Fear" or that is all he has ever known= "Ignorance". So, safety or guarantee and ignorance, may have been the primary motivation for his decision. Being a conservative, careful or less well informed individual, he could reasonably argue that his Savings Account with BOA is secure and protected by FDIC, (Federal Deposit Insurance Corporation protects bank deposits up to $100,000.00 of principal). That may be true but what Mr. Nyamangoro may be ignoring in his argument is the effect of inflation on his savings. If his money is earning 3% interest rate and the rate of inflation is at 5%, then it is very plausible that the "purchasing power" or future value of his money will decline or erode over time, due to the erosive effect of inflation, thus lowering his standard of living upon retirement, should he depend on a fixed income, e. g Social Security. One of the disadvantages of placing all your eggs in the "Savings" or conservative basket is the ravaging effect of inflation that tends to undermine the true value of your "nest egg", over time. Think about this for a moment, what does the bank do with your money when you open a Savings or deposit account? They sell your money in Auto-Loans @12%; Home Mortgage @6%; Personal or Student Loan @10%; Credit Card Loans @24%, etc. That is how banks make money; by selling your money to those who need it, and, at the end of the day, they give you 3% and the rest is theirs to keep. Which is why they call you a "Jackass" when you turn your back to them. You literally work for them. Banks are not Mints.

It is absolutely true that "securities" such as Mutual Funds, Stocks, Commodities, Derivatives, etc. are high risk investment instruments. Yes, venturing to invest in "securities" is risky business. Remember the most recent Stock Market Crash or "bust" in the Housing Market that almost stagnated the global economy. You also hear of expressions like “bubbles and busts" in Stock Exchanges or Housing Industry. You are also familiar with terms like "toxic assets". The reason for the high risk in these instruments is due in part to the "volatility", or "fluctuations" or "ups and downs" in market conditions. Even the most sophisticated forecasters or speculators can't predict with certainty, what the market will do in the short run, let alone long run. Low on the totem pole of risk will be instruments like Certificate of Deposit (CD), Money Market Accounts and Bonds etc. These instruments and more are sold or traded as “promissory notes", with a near guaranteed rate of return, except in cases of major default, thus making them less risky. High on the risk pole will be instruments such as "Currencies', Commodities, Stocks, Derivatives, etc. which depend almost exclusively on market conditions. However, it is worth noting that "securities" like those mentioned here are also protected or insured. Like FDIC on Bank deposits, SIPC (Securities Investment Protection Corporation), provides protection for up to $500,000.00 of the investor's principal, especially in cases of "preferred stock".

The reason why Dr. Porcupine may have chosen Mutual Funds to invest his $400.00, in spite of the risk involved, may be because of the concept of "diversification". Mutual funds help manage risks or spread the risk over a wide array of options to create a balance that would appeal to most investors, to maximize return on investment, while placing a check on the risk factor. They are also properly managed because of the pool of investors required to generate capital and select investment options. They can be tailored to meet each investor’s specific financial goals, risk tolerance and disposable income. They constitute a combination of instruments, ranging from bonds to common stock, to currency or commodities, etc. For starters, a Mutual Fund Account can be operated by the use of a simple method known as “Dollar Cost Averaging", and that may be one of the reasons why Mr. Porcupine was attracted to this investment vehicle, considering his small or limited initial investment. The risk of losing all your money in a bad investment Portfolio, is minimized by the ‘diversified' nature of Mutual Funds.

Mr. Frutambo is a high risk taker and so he desires to play with the big guys. He wants to own a piece of Home Depot, or Coca-Cola or Berkshire Hathaway or Unilever or South Pacific Rail Road or Delta Airlines or McDonald's etc, so he goes and buys "shares" in these companies. These "shares" are sold as "common or preferred stock". They can also be "bundled". By acquiring these "shares", Mr. Frutambo becomes a shareholder and gains through "dividend distributions", when the companies make money or he shares the responsibility of any loses, in bad times. Most investors in this category think in terms of staying power or long term. The volatility here is so strong it feels like being on a roller-coaster. This is where the adrenaline squeezing risk kicks in, if your tolerance level for risk is low. This is for savvy investors or those who work through "brokers" or investment bankers. The ups and downs are so frequent and sharp they scare the hell out of rookies or starters. IPOs (Initial Public Offerings) are very tempting, here as well. Stay away from this zone unless you know what you are about to get into or you trust someone who knows. Do not be fooled by any Broker or Investment Banker who might try to stir you one way or the other, by making guarantees about the "performance" of specific instruments or stock options. "Past performance is never a guarantee of future performance". Barring Day-Traders, investors here pay attention to their average gain over long periods of time than the frequent or rapid up and down movements taking place in their Portfolio.

Before you try any of the abovementioned investment strategies, please make sure you consult with your Accountant or Investment banker. Seek the free counsel of a good Financial Advisor, with fiduciary responsibility. Your adviser will conduct a comprehensive financial needs analysis to determine the following:



a) Your specific Financial Goals.

b) Your Disposable Income.

c) Your Income Protection Plan (various types of insurance e.g. life Insurance, health and disability insurance, etc).

d) Asset allocation.

E) Your Degree of risk tolerance, etc, etc.

This is not gambling; it is a science to a certain degree, and a complex one indeed. However, like anything else, you can't win if you don't play. Investment is a risky business but the 8% of the world's population that knows and applies this wealth of information, controls 95% of all the world's assets. The remaining 92% of us work for that 8%. THAT IS THE DIFFERENCE BETWEEN WORKING FOR MONEY AND YOUR MONEY WORKING FOR YOU. Cameroonian Entrepreneurs in the Atlanta Community take such risks every day, in their respective businesses, and that has made all the difference in their lives. No risk, no gain!!

In conclusion, it must be said that true riches or wealth cannot be measured or defined by the size of your bank account or the size of your house, or boat or number of automobiles in your garage, etc. As important as these material things may appear, true wealth is defined by your "self worth" or "self esteem". Not by other people's standards, but by those set by you and your God. True wealth is what you see when you look at yourself in the mirror. I do not know about you, but to a Christian, true wealth means simply being Christ-like. Money is but a bi-product and so are "assets".


 ***Sam Esale holds a Masters Degree in Applied linguistics from University of Durham, England  and he is a doctoral candidate in Management and Leadership Studies at the American Bible College and University ***


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