Basics of Investing(Part 3)

Learn about investing: compound growth

In our last article, I left you with this statement. The potential of higher returns necessarily comes at the expense of more risk and I indicated that this particular wording was chosen very carefully.

Again, many people have heard the shorter and simpler phrase Risk and Return. But as per my knowledge, unsuccessful investors focus too much on the return and not enough on the risk.

Part of the reason is that it can be very seductive to think about how you can grow your wealth when you first learn about compound growth.

So, in today's article I’m going to first explain What compound growth is? Because it's a very powerful concept which tempts many people to shoot for higher returns.

But in the next article I take a look at the trade-off which is Risk.

So, What is compound growth? 

First you should know that there are a number of phrases that all basically mean the same thing.

Sometimes, people will refer to this concept as compound interest, exponential growth, compounding returns and so on. They all refer to the same concept.

Simple interest or growth is different than compound interest or growth and we'll use an example to compare the two to make the differences crystal-clear.

Let's say that we have $100 and we found an investment that pays 5% interest per year

$100 * 5% =$5. 

So, at the end of the year our $100 investment has earned us $5 in interest.

Scenario 1 will be our simple interest scenario. So in year one our original$100 earns 5% so we had $5 in interest for the year.

Now, let's say we take this $5 and we spend it on a chocolate roll and I wouldn't blame you because chocolate rolls are like crack.

So, at the beginning of year two, we'd still have $100 invested and it would again earn 5 % which would be another $5.

But every year we spend the earnings on chocolate rolls and if you remember every year we would be able to buy slightly less due to inflation. So, our annual chocolate roll gets smaller and imagine we did this for the 30 years.

Every year we would earn $5 in interest and every year we would spend it. At the end of 30 years. Let's say we sold our investment to get our $100 back in total we are in $5 an interest per year for30 years or $150 in total interest earned.

In scenario 2, the compound interest scenario, let's say we didn't spend the interest earn but rather reinvested it back into this investment that earns 5% interest every year.

So, at the end of year one, we now take the $5 of interest earned and add it to our amount invested.

At the beginning of year two we now have $105, that will earn 5% for the next year. So, when year two we have $105 earning 5% interest which is $5.25

At this point you might be thinking Wow! A whole extra 25 cents what's the big deal. Well it is a big deal once you get through multiple cycles, reinvesting our $5.25 cents means we are starting year three with

$105 + $5.25 =$110.25

We again earn 5%in year three and $110.25 * 5%=$5.51

Let's see what happens if we keep taking the interest and keep reinvesting it every year. In year four, we start with $110.25 + $5.51=$115.76

That will earn $5.79 in interest. Reinvesting that in year five we start with $121.55 and earn $6.8 .

Let's skip forward to year ten, we start the year with $155.13 and earn $7.76.

Fast-forward again to year twenty and we start the year with $252.70 and earned $12.63

And in year 30 we start with $411.62 * 5% = $20.58 that year to end up with $432.19.

So, if we subtract our initial investment of $100 we're left with a total amount of interest earned over these 30 years of $332.19.

Now remember in scenario 1 where we earn simple interest we earned $150 in interest over 30 years.

In scenario 2, with compound interest we earn $332.19 over that same time period and in both cases our investment earned 5% per year.

So, for our definition of compound interest or growth, compound interest is when you have earnings on your earnings.

Instead of spending the money your investment earns you reinvest it so that this new money can also earn a return.

So now we know what this concept is but why can it be so powerful and also so seductive.

Well let's take a look at what happens to our comparison if we change the rate of return. 

If we were able to earn 7% every year then we would have earned $210 in total interest in scenario one but $661.23 in scenario two. 

Now you'll see a lot of references in older books on investing and even on the Internet today to people using a 10% rate of return for projections like these. 

If you could get that for 30 years straight, scenerio one would have earned us $300 interest while scenerio 2 increases to whopping $1644.94 in interest earned.

Well, that looks pretty attractive and so many people would say Hey! let me put away more than just $100 one time. Let me consistently invest $100 per month. 

What if I started at age 18 and retired at 65, that's 47 years of making consistent contributions. With a 5% rate of return that would end up being $226,428.

With a 7% rate of return that increases to $438,642.

Invariably, people will play with the multitude of calculators available online and start to play with the variables just like this and I guarantee that most of you who do will eventually start using some really high rates of return like 10% over all 47 years and if you did that that would give you an ending value of just under 1.3 million dollars.

I think we've proven that focusing on the rate of return when coupled with the power of compounding growth is something that will get people really really excited and that's generally a good thing, but it does not come without cost.

It is not as simple as simply picking investments that offer the potential of higher returns. The potential of higher returns and again I'm highlighting that word potential necessarily comes at the expense of more risk.

In the next article, we're gonna start to answer the question.

What is risk and how this is the trade-off for the potential of higher returns?

Hope you liked this article.

If you didn’t read the 2^nd part, click here.