Friday, January 26, 2007

The power of compound interest

When asked what is mankind's most wonderful invention, Einstein's answer was "compound interest". Guess most people wouldn't want to argue with Einstein, unless you think you can win a Nobel Prize too. But what's so good about compound interest?

For those lao jiao value investors, sorry for writing this simple post which you all would already know and swear by it.

Ok, for those value investors wannabies, this post is gonna change your life. So get ready.

If you buy $10,000 of Singapore govt T-bills (i.e. govt bonds or Treasury bills) today, it earns you 3% interest, bcos of compound interest, it will become roughly $24,000 in 30yrs. Without compound interest, it's just $19,000. That's 55% difference (14 divided 9). If you put it in the bank, it earns 0.025% and becomes $10,700 in 30yrs. You might have as well put it under your pillow.

Now imagine if you can save $10,000 every year to buy T-bills for the next 30 yrs, and they give 3% interest. Do you know how much it will become?

It will be close to $500,000.

If you save $20,000 every year and buy T-bills for the next 30 yrs, you get close to $1,000,000. If you invest and get 5% instead of 3%, you get close to 1.5mn, if you invest as well as an average investor on Earth, i.e. you earn 8%pa, you get $2.5mn. If you invest as well as our hero, Warren Buffett, you get 24%pa and you get *drumrolls* $65mn. That puts you in the top 30 richest Singaporean list.

This is the power of compound interest.

You don't have to do a lot, save enough, earn a good rate of return, and just wait. You will be a millionaire in 30 yrs. Now that seems quite easy right?

So why we don't see millionaires all over Singapore? Well actually they ARE all over Singapore but too bad we are not one of them. There are a few reasons:

1) Discipline: Most pple, after working long and hard for one month will grab their paycheck and spend it on some gadget or some luxury bag worth $7 selling for $700 to reward themselves, including this blogger here. Who has time to think about saving for 30 yrs?

2) Diligence: Putting the money you saved in fixed deposit is not enough. Only when there is some campaign, you get 3% but usually it's only 0-1%. So you have to put them in T-bills and rollover every few months. That's difficult. Imagine spending your precious weekends in banks to rollover these stuff. Now we have POEMs, so pls go open an account today. But still, it's a hassle.

3) Time: Now compound interest works best when the time period is long enough. Warren Buffett took 50 yrs, for the illustration above, you need 30 yrs. Most pple can only have some savings after major cash outflows like wedding, buying a house, having kids etc. So even if you start at 25, you will only become a millionaire at 55.

So that's why it seems easy but it's not. But there people who does this and got there. Their parents started for them when they were like 10 yrs old, and when they are 40, they become millionaires. Well, don't blame your parents, just make sure you try your best to help your children! Hehe.
Post a Comment