Often times, we heard someone lament how he/she wished that they are wealthy or came from a rich family. They often spend most of the time thinking and dreaming what they would do if they are loaded with cash. I believe most people do think of that at least once in their lifetime. After much toiling and failure to accumulate wealth, they started to think that financial independence is beyond their reach. They gave up their dream to pursue financial abundance. There were also stock investors and traders that had lose their fortune in the stock market. They too, gave up their hope to make their millions and started to see the impossibility to beat the market. Quite contrary to popular belief, financial abundance is actually within the reach of every single human being that is financially literate. If you are one of them, fasten your seat belt and join me in the journey to uncover one of the most wonderful discovery of the world and that is the discovery of the "Secret of Compounding Interest".
We are living in a fast moving society and we expect things to be accomplished instantly. We expect things to happen within a button press. Sadly said, we also expect to be financially savvy just by trial and error. However, things don’t happen that way. If we want to be a cook, we have to learn cooking. If we want to be an engineer, we have to study engineering. So, if we want to be financially independence, we have to study personal finance. Stock traders and investors are not born, they are made. They probably study corporate finance, accounting, stock chart analysis, fundamental analysis and technical analysis. Enough said. We shall proceed to learn more about gaining financial freedom by studying about the secret of compounding interest. By the way, all the big financial banks and investment companies made their fortune using this principle of compounding.
Compound interest is defined as adding interest to the principal and the next interest calculation is based on the enlarged principal amount. A cash deposit of $1000, for example, earning 10% interest rate per annum would be making $100 on the first year and $110 on the second year as the $100 was added to the base principal of $1000. This goes on every year and the amount of interest made would be growing bigger and bigger as a result of interest added to the principal amount.
Sounds simple but how does it makes so much difference on my bank account? It does make a lot of difference to our net worth. As you can see that there are 3 variables in the calculation of the future value of your investments. Can you figure out what are the variables? Let us put it in the context of stock trading business.
3 Variables to Calculate Future Value of Trading Capital
- Initial Trading Capital Amount
- Return of Investment (ROI) which is basically Interest Earned or Rate of Return
- Time or Duration of Investment
In a nutshell, the more we put in as the initial trading capital, the more interest we could earn out of it. More interesting would be the rate of return and the duration of investment. I will give some examples to show how lucrative compounding interest could be. Let us begin the quest for financial abundance with $1,000 as our starting trading capital.
If we could earn 15% on our trading capital consistently:
- In 1 year: we will have $1,150
- In 5 years: we will have $2,011
- In 10 years: we will have $4,045
- In 20 years: we will have $16,366
If we could earn 18% on our trading capital consistently:
- In 1 year: we will have $1,180
- In 5 years: we will have $2,287
- In 10 years: we will have $5,233
- in 20 years: we will have $27,393
If we could earn 20% on our trading capital consistently:
- In 1 year: we will have $1,200
- In 5 years: we will have $2,488
- In 10 years: we will have $6,191
- in 20 years: we will have $38,337
As we can see in the examples above, the higher the rate of return, the higher the future value we will have on our trading account. Even a slight difference of the interest rate that we used to calculate our future wealth potential, it does bring a big difference especially in the longer period of time. This is the classic example of how 1 degree of inaccuracy in firing a rifle does not impact the result if the target is at a stone throw away but does big difference if the target is a mile away. Ok, you might say, after 20 long years, we could only make $38,337 which is not sufficient for our old-age retirement plan. True enough although we overlook that it was 38 times of our initial trading capital. How about if we start with $10,000 instead of $1,000? That would be $383,375 for our retirement.
Now, let me test you to see if you really catch the secret formula to abundant wealth. For the $1,000 trading capital example above, what would be our net worth if we consistently make 15%, 18% and 20% for 40 years? By superficial logical thinking, we would say 40 years is double of 20 years, so the net worth would be approximately $80,000 for 20% annual return. If you think so, then let me surprise you a bit. Look below for answer.
- In 40 years with 15% return, $1,000 would become $267,863
- In 40 years with 18% return, $1,000 would become $750,378
- In 40 years with 20% return, $1,000 would become $1,469,771
So, after all, time does make a HUGE impact to our financial well-being even we have mediocre return on investment (ROI). So lesson learned. Start early in savings. Invest in financial education to increase our capability to earn more rate of return on our capital.
As this is just an introduction to the power of compounding, I will elaborate more and gives more insights as how we can achieve this in our investment and speculation business. I will also talk more of some of the failure of stock investors and index futures traders due to negligence to this concept.