The world is full of wonders. The Great Pyramids of Giza, the Hanging Gardens of Babylon, the Lighthouse of Alexandria, the Temple of Artemis, and the Colossus of Rhodes. In finance, there is one single wonder that stands out above the rest – COMPOUNDING.
The majority of humans are not aware of this wonder becuase it requires a rare commodity – PATIENCE. We are impatient. We want to get rich quick. The reality is that getting rich requires compounding and patience. Let me explain.
Investing $100 per month at a return of 10 percent per year will deliver $226,048 after 30 years. How much would I have after 30 years if, instead of 10%, I generate returns of 20% year. The human brain, in all its feebleness, would reason like this – if I am earning double the return (20 percent instead of 10 percent), it should have double the money - $450,000.
What would you say if I said that by doubling the annualized return you would earn TEN times more? Your $100 investment at 20 percent per annum will yield $2,297,783 in 30 years!! Hiow is this possible? Through compounding.
Albert Einstein said that the power of compound interest "the most powerful force in the universe" and went on to say..." he who understands it earns it; he who doesn't, pays it."
You earn 10 times more with twice the return over 30 years because you are reinvesting your returns. You are earning returns on your returns. This is best understood with a simple example.
Assume you invest $100 on day 1 at a return of 20 percent per year. In one year, that $100 has grown into $120. In year 2, again you earn 20%, but on $120. This means that you made $24 which is actually 24 percent on the original $100 invested.
Look at how the returns take off the longer you invest.
Year 1: $20 (20 percent on $100)
Year 2: $24 (24 percent on $100)
Year 3: $28.8 (28.8 percent on $100) …….
Year 10: $103 (103 percent on $100) …….
Year 20: $638 (638 percent on $100 …….
Year 30: $3,956 (3,956 percent on $100)
By year 30, you are earning an astronomical return on you’re your initial $100 because the investment has snowballed as you reinvest your returns.
So how do we put compounding to work?
Rebel Finance is built on the foundation of investing more and working less. You will notice that I said “investing”. This is an action verb in the continuous tense. It is an ongoing and continuous process. Many people do not invest because they are under the false impression is that the only way to invest is through large lump sum amounts. So they set off on an investment project religiously putting money away into a low or no interest savings account until they have accumulated enough money to invest.
There are two problems with this approach. Firstly your money is laying idle in that account. It is sitting on the couch, binge watching Netflix and getting lazy. It should be in the gym, pumping iron and sweating for you. The second problem is that the money in your savings account is vulnerable to unplanned withdrawals. In moments of carnal weaknesses there is always a temptation to dip your sticky little fingers into the savings jar. For this reason, you need to get into the investing mindset. In the same way that it is important to set short term savings goals, you also need to invest smaller amounts continually and consistently.
Now you need to invest your savings into a assets that meet the following requirements: 1) they accommodate small monthly contributions
2) they provide easy liquidity – your investment can be liquidated quickly and without penalty
3) they are transparent – you have pretty good idea as to how they generate revenue
4) they have a long track record of delivering inflation beating returns
In my opinion, the assets that best comply with these four requirements are publically listed companies, or the stock market. It is easy to create a debit order off your bank account to commit to a monthly investment into the stock market. Secondly, most stocks are liquid. Thirdly, listed companies need to disclose their financial information every quarter and finally, the stock market is an inflation beater. . Over the past 30 years, the Standard and Poors 500 Index has delivered compounded returns of approximately 10 percent. This is better than a poke in the eye with a blunt stick and one needs to take into account that this return includes three major stock market crashes – the dot.com bubble bursting in 1999/2000, the collapse of Lehman Brothers and the Great Recession of 2008, and the Coronavirus pandemic of 2020.
So what is the plan?
Step 1: Relax
The stock market brings out the worst in us because we believe it will get us rich quick. Most people are terrified of the stock market because it exhibits wild and volatile swings and this is true – in the short term. The stock market, over the longer term, tends to be more predictable and benign. Your first step is to recalibrate your opinion of the stock market and take a long-term view. You need to be patient and you need to be religiously disciplined in your investment.
Step 2: Monthly Contributions – Annual Consultations
Every month, you need to commit to investing a minimum amount of cash into the stock market and you are only allowed to check your account statement once per year.
Step 3: Choose a Low-Cost ETF
I am not a huge fan of ETFs because they are too diversified and at Rebel Finance we discourage investors from committing their money to overly diversified instruments (https://www.rebel-finance.com/post/three-reasons-you-should-never-invest-in-a-well-diversified-portfolio). But we also understand that not everyone has the desire or time to analyze individual stocks, which means an ETFs can be a powerful financial tool. I would recommend a broad-based country or global ETF such as the SPY or IVV.
Step 4: At Least $100 (or your local currency equivalent) a Month
All you need to do is invest $100 per month. To understand how extremely attainable $100 per month is, I did a quick Google search on what $100 can buy you these days: Eight or ten movie tickets, 10 months of Netflix, four or five new movies on DVD, fifteen used DVDs at a yard sale, lunch for four at a fairly nice restaurant, 40 cheap burgers or 90 candy bars.
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