Saturday, January 21, 2012

Investment: Power of compounding + Cost of time

In pasar malam, there are hundred of stalls. You are there to buy a bag, and found it at a stall. If someone just told you there is cheaper one at other stall, how much time would you spend to find the “cheaper” bag by walking down the street to find that particular stall?

If we are spending our spare time at pasar malam and buy the bag at the same time, who care how long we could find the cheaper bag? We hope we can kill more time than that! But what if, we left our job half-way, purposely to buy the bag from the pasar malam, and need to get back to carry on the job? Hence, another question will we will ask ourselves “how much cheaper is the bag in another stall?” or “how important is my job?”.

They are just examples, which is quite abstract because we can’t count “how expensive” the time is. But, from the view of investment, we can actually calculate it!

Previously I have calculated how much difference the investment return generated is if we start investing at different age: Investment - Start earlier, more beneficial

In this blog, I just want to show the difference of the return that comes earlier vs. later.

Average Return vs Real Return

Sometimes, we heard some insurance/assurance agents say “xxx package will bring you average return of 5% after 10 years”. The average return is calculated simply by:

Average return = Total return for 10 years / 10 years

Total return for 10 years = (Final value – Initial value)/Initial value

For example, we buy xxx package at RM100,000. The agent tells you that you may get RM150,000 back after 10 years, which is 50% total return or average 5% annual return!

What if, we get 5% annually every year and being compounded for 10 years? This means we reinvest the amount of money we get every year, instead of waiting for 10 years to get 50% in a lump sum. Let’s see what is the difference:

Assume we start investing with amount of RM100,000. After the first year, we get 5% return, which is RM5,000. By investing this RM5,000 again, which we have now RM105,000 invested value, then we will have RM5,250 (RM105,000 x 5%) after 2nd year. After compounding, compounding and compounding, we will at 10th year get RM162,889.46, which is 62.89% instead of 50%!

The result is so much different between compounding and non-compounding effect. The power of compounding, it’s just that simple. The faster we get the return, the higher return we get at the end of the day.

Don’t simply follow what the agents or bankers said, you can actually calculate yourself! You can setup your own portfolio!

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