Riaz emailed me some times ago to seek opinion on the matters about investment and compound interest. Here is the email I received:
I am an avid reader of your blog and would like to thank you for sharing and providing all of us with your valuable thoughts and tips.
Lau, I have lately read some books on personal finance and the key idea behind building wealth is savings over longer period of time. Popular terms like ‘Latte factor’ etc. are also the branding of the same concept. Given that I am not an expert in personal finance, I have tabulated a simple spreadsheet based on $20 daily savings over 30 years. I have taken an assumption of 10% annual interest or 0.0273% daily. The future value calculated for the given values is $1,392,641.86, and it is plotted against values earning no interest.
I would like to confirm my understanding whether these calculations in the attached spreadsheet are correct. Also I would like to get an opinion, which investments (shares, bonds, mutual fund etc) can be utilized to achieve this kind of results. Putting this question from a different perspective, the savings account interest rate at banks is minimal to achieve these results, and I am not too sure how we can utilize shares as an investment (since we do not know the daily compounded interest rate it will be earning).
I will appreciate your thoughts on this.
There are several questions asked by Riaz. Actually, I repeat reading the email a few times before deciding how I should answer Riazâ€™s questions. Here, I break the answers into several sections.
Is the calculations in the attached spreadsheet correct?
You can download Riazâ€™s Excel spreadsheet. (right click the link and â€œsave file asâ€)
The spreadsheet is nicely done with the result shown in line graph. You will see the effect of compounding interest is exponential.
I verified the figures and calculations and found that Riaz did a great job. The calculations are accurate.
It shows that you should really make use of the wonder effect of compounding interest. I talked about it in depth in my previous article – Effect of Compounding Interest. The article is also being included in my book â€“ Top Money Tips for Malaysians.
Referring to Riazâ€™s spreadsheet, you will find that at later stage, the difference between a compounded return and stagnant capital is so significant. You really lose a lot if you save the money under your pillow (or even in the bank saving accounts). It is even worse if the money is spent now on things that donâ€™t provide any value to your life. Nowadays, savers lose.
Which investments can be utilized to achieve the results?
The exponential difference shows that you should invest now, regularly and preferably in a higher return investment vehicle. Riaz uses 10% return per annum in his Excel illustration. Now the question is how to get a return of 10% per annum? Should you utilize unit trust, real estate, shares, or doing your own business?
All roads lead to Rome
Yes. There are many methods and investment tools that can provide the result of 10% per annum return. But which one is suitable for you? This is big topic to cover.
For a passive investor, who normally doesnâ€™t want to learn and actively involve in investment activities, unit trust funds seem to be the answer. Looking back the historical data of unit trust fund performance, a balanced portfolio does provide 10% return per annum most of the time.
If you have enough financial education, you can become an active investor. You can learn a specific investment tool, master it and become an expert. When you are an expert in certain field, you have certain level of control over your investment.
There are people making a lot more than 10% return in FOREX trading, in stock trading, in real estate investment, in their own businesses, in developing websites, and â€¦â€¦..
So my summarized answer for â€œWhich investment can produce high return?â€ is
Choose the investment you love, learn about it, master it, and be an expert!
All roads lead to Rome. For the safe road like â€œbank saving accountsâ€, â€œfixed depositâ€, and â€œgovernment bondsâ€, the journey is far and you will meet many same people with the same â€œslow mindsetâ€. When you reach the destination, youâ€™ve probably missed out a lot of exciting stuff in your life.
Instead, you can choose the exciting path. As you learn more along the way, you will find that the road is shorter, broader and more adventurous.
So which investment do you prefer?
What if the compounding interest rate is unknown?
When we are doing calculation, we assume a certain percentage of return to estimate the future value of our investment. If the return rate is fixed and guaranteed (like Fixed Deposit), the estimated value will turn out to be more accurate compared to the real value in future. But for many investment vehicles, there is no guarantee. The return is in fact up and down like a roller coaster ride.
What you can do is to use an average return you are comfortable with. For someone who is not an expert, you can diversify and get probably an average return of 7% from your stock portfolio. Meanwhile, for someone who does thorough research like Warren Buffett, he manages to get more than 25% per annum average return.
I wrote a tutorial on how to calculate and estimate the average return of your investment portfolio. Refer the article to learn more about it.
I receive quite a lot of emails asking for advice nowadays. I am sorry if you still havenâ€™t heard from me yet. In fact, Riazâ€™s email was received in March 2009. Stay tuned!