The power of compounding in financial planning
N the tapestry of financial wisdom, there exists an eighth wonder of the world, an invisible force that shapes destinies and accumulates wealth beyond imagination. To understand this marvel, let’s journey back to ancient China, where a tale unfolds, featuring a wise man named Wong Li and an unwitting emperor. Wong Li, having rendered invaluable assistance to the emperor, was granted a unique reward. Little did the emperor realize the profound impact of Wong Li’s seemingly modest request — a single grain of rice, compounded daily for two months.
Long time ago in China, a story was told about a certain man named Wong Li. He was a smart man and had helped the emperor of China many times in solving the country’s problems. The emperor, wanting to show his gratitude, insisted that Wong name his reward. “Great emperor, I have only a very simple wish that I ask. I would like to ask for a grain of rice today to be placed in a stockroom. Every day for two months, whatever rice remains in the stockroom must be matched by an equal number of grains.
If I leave my single grain of rice tonight, one will be added to it. If I leave those two again, then there will be two more grains added on the next day. If you could grant me this wish, I would be the happiest man alive in China.” The emperor thought he was getting a good bargain, so he agreed. By the 12th day, the emperor would only need to give 2,048 grains of rice. But after a month, the emperor realized the price of his agreement and called Wong into his castle to be put to death. Why? The total grains of rice the emperor had to pay after the end of the second month, assuming a 62-day period was 4,611,686,018,427,390,000 grains of rice or 4.6 quintillion grains. That is more than all the rice in China combined.
You might have guessed right. The eighth wonder of the world is called compounding. The above story took it to the extreme and used what mathematicians called a geometric progression. What do you think would have happened if Wong Li had always taken one to eat and left only one every night? The answer is, at the end of the 62-day period he would have exactly 62 grains of rice. What if he took all of the additional grains every day and leaves only one grain every time? Well, he would have ended up worse than the previous scenario.
He’ll end up with the same one grain of rice at the end of the 62-day period. Knowing this basic principle and applying it could go a long way in making your strategic investment decisions. It’s not how much you earn that counts. It’s how much you get to keep and reinvest. If you’re having trouble coming up with surplus cash for saving and investing, consider the following guidelines: Remember to pay yourself first. This is a good rule to follow, especially for those needing more discipline. It simply means setting aside some money for investment first before paying off regular expenses.
Second, live within your means. Every time an urge to go on a shopping spree arises, ask yourself these four questions. One, do I need it? Differentiate between a need and a want. Two, what is the before tax of doing it? Remember that the money you’re about to spend is after tax. Three, what is the impact of this on my ability to meet my financial objectives? Think long term. Fourth, is there a less expensive alternative? Less expensive substitutes and alternatives abound. Make use of the benefits of free enterprise.
After being introduced to compounding, let’s get to know its sidekick. But first, try answering this.
“John and Jeremy are two close friends who happen to have the same birth dates. John, upon getting his first job at 22 years old, invested P5,000 every year for the next eight years at 10 percent. But he eventually stopped investing after getting married at age 30. But he did not withdraw any money. He just left it to be reinvested at 10 percent per year. He anticipates using it for his retirement. Jeremy, on the other hand, started investing after being married at age 30. He invested P5,000 every year for the next 25 years at 10 percent per annum. At 55 years of age, they both decided to retire. Who do you think has more money for retirement? Pause for a while before reading the answer below.”
The answer might surprise you. John would have accumulated P681,474.67, while Jeremy will only have P540,908.83. John had more despite the fact that he contributed a total of only P40,000 while Jeremy contributed a total of P125,000. We’ve just proved the Filipino saying: “The early riser beats the hard worker.”
There you have it. You’ve just learned two important basic financial concepts you can use in planning your financial future. By utilizing the power of time and the power of compounding to your advantage, you will reach your financial goals easier and faster. So, what are you waiting for? Start now!
Josefino Gomez is a registered financial planner of RFP Philippines. To learn more about financial planning, attend the 106th RFP program this March 2024. Please email info@rfp. ph or visit rfp.ph for details.