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Savings
and Investment Calculators
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 The
Companion Advisor: Techniques
& Methods
The power of compounding
A Companion Advisor Article
Compounding, earning interest on interest, is best
described by an ancient story.
A Maharaja ruled the Indus Valley, in northern India, in the sixth century.
Bored, he asked his court gamesman to develop a new game for him. The
gamesman created chaturanga, the army game, the precursor of chess and
played on a board of sixty-four squares. The Maharaja was delighted and
asked the gamesman what he would like as a reward.
"Nothing much," answered the gamesman, "Just one single
grain of wheat on the first square, two grains on the second, four on
the third, eight on the fourth, and so on across the board."
In calculating the gamesman's reward, the Maharaja discovered that, even
before he was halfway across the board, he owed the gamesman more grains
of wheat than existed in all of India. He solved his problem by ordering
the gamesman executed.
The gamesman was earning interest at the rate of 100% per square, far
beyond what we can expect. However, the principle of compounding
interest remains the same. Earning interest on interest can add up
over the long term.
Suppose you have a mutual
fund which performs at the rate of 8% per year. If you invest $1000
annually, and leave all your money in the fund, after twenty-five years
you will have $73,110. If you invest $10,000 annually, after twenty-five
years you will have $731,100.
Investing for the long term and reinvesting the earnings pays off. The
annual performance makes a great deal of difference, too. If our mutual
fund earned 10% rather than 8%, our twenty-five year nest egg would swell
to $ 983,500. A gain of $252,400 with the same annual investment, but
a 2% higher rate of return.
The two most important factors in compounding, therefore, are time and
rate of return. The power of compounding leads to some general rules in
investing:
1) Don't let funds accumulate without earning interest. The money in your
mattress, and in a non-interest-bearing bank account, is earning 0% per
year. When you factor in inflation, you are losing
money every year at the rate of inflation.
2) Whatever your investment, make regular deposits. If you skip a single
$100 per year investment at 12%, after twenty-five years you have lost
$13,333.
3) Look for investments that pay the highest rate of return without the
risk of losing sleep at night. Small differences in return add up over
the years.
4) Arrange for at least four month's salary to be liquid, cashable at
any time in case of emergencies such as job loss. Even a 15% return on
your investment over twenty-five years may not be worthwhile if you have
to pay a huge penalty for cashing in early.
5) Every dollar you owe in credit card balances, personal and car loans,
and mortgages is a dollar you are not investing. Pay off your after-tax
loans as soon as possible to free your money up to work for you, not your
creditors.
6) Ask your Fiscal Agent - investment
advisor how to best make the power of compounding work for you, based
on your financial picture and the amount of money you have to invest.
There are many alternatives with differing risks
and rates of return, and an investment advisor can help you make the best
choice.
If you follow these general rules, you can create a sizable nest egg for
yourself without the risk of being executed.
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