How the power of com­pound­ing can make you wealthy

Asian Journal - - WORLD - Ea­monn Percy

Have you heard of “The Tale of the Wheat and Chess­board?” It is based on a story about the in­ven­tion of the game of chess. The story goes that the in­ven­tor showed the chess­board to his king, who was so im­pressed that he asked the in­ven­tor to name his own re­ward for the ac­com­plish­ment. The in­ven­tor, who un­der­stood com­pound­ing, only asked that he be given a sin­gle grain of wheat for the first square, dou­ble on the sec­ond square and so on for the bal­ance of the board, which the King quickly agreed. The king sent his trea­surer away to get the grain for the in­ven­tor and af­ter he had been gone for a week, be­came wor­ried. He called for him to ask what had hap­pened, and was told that, through the power of com­pound­ing, the King owed 18,446,744,073,709,551,615 grains of wheat! The King had got­ten a quick les­son in fi­nance and the power of com­pound­ing.

The ex­po­nen­tial ef­fect of com­pound­ing is quite ex­tra­or­di­nary, as the above ex­am­ple il­lus­trates. You don’t have to have a math de­gree to see how the ef­fects of com­pound­ing can work to your ad­van­tage, par­tic­u­larly if you are early in your life and ca­reer and you main­tain a dis­ci­plined, struc­tured ap­proach to monthly sav­ings and in­vest­ment.

For in­stance, ac­cord­ing to a re­cent CNBC ar­ti­cle, a 25-year-old per­son who makes $40,000 per year and con­trib­utes 10 per­cent of his or her salary to an in­vest­ment plan an­nu­ally will amass $3.9 mil­lion by the time he re­tires at age 67. That fig­ure as­sumes a 50 per­cent em­ployer con­tri­bu­tion match, a 5 per­cent es­ti­mated salary in­crease rate an­nu­ally and an 8 per­cent in­vest­ment rate of re­turn. Us­ing all the same pa­ram­e­ters, that same per­son would have $2.5 mil­lion—or $1.4 mil­lion less—if he had started sav­ing only 5 years later at age 30. Due to the power of com­pound­ing, a fiveyear head start re­sults in a sig­nif­i­cant dif­fer­ence in the to­tal.

When we were chil­dren, on the first snow­fall we would rush out­side to build a snow­man. Start­ing with a hand­ful of snow, we would start rolling the small snow­ball in the snow un­til it got so large we could barely push it. This is like com­pound­ing re­turns; the ef­fort is at the start; the re­ward is in the per­se­ver­ance over time.

My wife and I put three kids through univer­sity by start­ing a col­lege fund the month they were born, and con­tribut­ing only $100 per month into a blue chip, div­i­dend pro­duc­ing stock port­fo­lio. The ac­cu­mu­lated ef­fect of the monthly con­tri­bu­tion, stock price in­crease and rein­vested div­i­dends paid for col­lege tu­ition 20 years later.

Here’s how to set your­self up to take ad­van­tage of the power of com­pound­ing:

1. as soon as you have even a mod­est in­come, and prefer­ably in your teenage or early adult years. If you are a par­ent, en­cour­age good in­vest­ing habits in your chil­dren by set­ting up an in­vest­ment ac­count (such as an In­trust Ac­count) or buy­ing shares in a com­pany that pro­duces div­i­dends.

2. Once you start a work­ing ca­reer, start im­me­di­ately in­vest­ing 10% of your net earn­ings into solid, blue chip, div­i­dend pro­duc­ing stocks. Make sure you select to rein­vest the div­i­dends. Live off the bal­ance and never, ever touch the prin­ci­pal.

3. Be pa­tient and hang in for the long­haul. Stock mar­kets will go through long term trends and short term pe­ri­ods of in­tense volatil­ity. This is nor­mal. Re­sist the temp­ta­tion to liq­ui­date dur­ing a pe­riod of sig­nif­i­cant mar­ket melt­down, such as in 2008. Think long-term, as in decades, not years.

4. Be care­ful with mu­tual funds, par­tic­u­larly those with an­nual fees great than 1%. While the fee may seem small ini­tially, it will eat sig­nif­i­cantly into your re­turn and be ex­pen­sive over the long run. In­ves­ti­gate good qual­ity in­dex funds or ETF (Ex­change Traded Fund) as an al­ter­na­tive, or build your own port­fo­lio.

Ea­monn has a B. Eng. (Elec­tri­cal) from Lake­head Univer­sity, MBA (Fi­nance) from Univer­sity of Toronto, and has com­pleted Ex­ec­u­tive Ed­u­ca­tion at Stan­ford Univer­sity Grad­u­ate School of Busi­ness. He lives in Van­cou­ver, Canada. Fol­low him on twit­ter @Ea­mon­npercy

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