The Single Most Important Thing to Know About Investing
If you put $10 in a bank account and earn 3% interest, the money will double every twenty-five years. Even after a long lifetime, you might have only $30 or $40 dollars. “No way to get rich,” you are thinking.
But humanity goes on. Imagine that the bank account kept on doubling every quarter century for 1,000 years. The original $10 would then have grown to a sum worth over two times the world’s total wealth today. Compounding money over long periods of time produces fantastic results.
OK, but if so, why has humanity not done better? Why are billions still trapped in poverty? Well, in order to compound, one must first invest, and for most of human history people were afraid to invest. Wealth was either spent or hidden. To bring it out in the open and invest invited theft, either by other people or, very commonly, by governments. It did not pay to invest, and not investing, humanity stayed poor.
These problems have not gone away, but beginning in the 18th century, in Britain and America, it became somewhat safer to invest and the results were spectacular.
By investing sums larger than $10 and by compounding at a faster rate than 3%, lots of people became rich. In the process they also bought a lot from others and hired a lot of people and the wealth spread. Wealth really grows if we can refrain from spending, save and invest, and then reinvest whatever return we get from the original investing.
Leading Economist John Maynard Keynes scolded that this was “jam tomorrow but never jam today.” Meanwhile “jam tomorrow” pulled billions out of poverty. When young, Keynes was also a fan of borrowing to increase the capital for his market bets but at one point went bankrupt and had to be bailed out by his father. For most people, the formula for getting reliably rich is simple: don’t spend, don’t borrow, don’t gamble, and do make well considered long term investments that have plenty of time to compound.
A Handy Formula For the Mathematically Inclined
FV = PV x [1 + (i / n)] (n x t), where:
· FV = future value
· PV = present value
· i = annual interest or return
· n = the number of compounding periods per year
· t = the number of years
A useful shortcut to the formula is the Rule of 72. If you divide 72 by the rate of return you hope for, it will give you the number of years to double your capital. For example, if you start with $25,000 and earn 12% a year, it will take six years to double to $50,000. Assuming the same rate of return, six years later you would have $100,000. Eighteen years later $200,000, twenty-four years later $400,000, thirty years later $800,000, thirty-six years later $1.6mm, forty years later $3.2mm, and forty-six years later $6.2mm.
As the Rule of 72 demonstrates, even small increases in the rate of return can speed up the time when you begin to compound large numbers, the magical moment when it all begins to pay off spectacularly.
Quality of Investments Matter
Another point worth emphasizing: it is the quality of investment that matters. A wise investor starting out with $25,000 will do far better than an unwise investor starting out with $1mm. The latter will very likely just lose the entire stake. A common mistake is to reach for an unrealistically high rate of return or too fast a return, often by borrowing money to speed things along. It is investors, not speculators*, who succeed, and they succeed above all by being patient.
This is all at a very high level, but it also applies to a myriad small, mundane decisions we all make. Let’s assume that you forego a little luxury one day, perhaps a special coffee drink priced at $10. Instead you invest that sum and earn the preceding 12%. In 36 years the $10 has grown to $640. Add in a few more foregone luxuries and you might have a significant nest egg. Does this mean we should all turn into misers? No, but maybe we could make our own coffee drinks.
Don’t Forget About Inflation
One last caveat. The cost of everything we buy may also be rising during the investment years. What if you turn $25,000 into $6.2mm only to find that a currency collapse has repriced a cup of coffee to $1mm? In that case, you are actually worse off than before. It is always the return we earn minus inflation, usually called the real rate of return, that counts.
These and other complications aside, compounding capital and knowing how to construct the financial books and records required to track it are among the most important and fruitful inventions of all human history.
WRITTEN BY:
Equity Edge | CHIEF INVESTMENT OFFICER
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Author’s Note:
*The word speculator has two quite different meanings. In common language it means someone who gambles on securities, regarding markets as akin to casinos. In technical economics it refers to someone who takes the other side of hedgers in derivative trading. The latter play a useful role and any gain is payment for service rendered. I have used the word in the first sense.
