Investing 101: Compounding - Part 3

Albert Einstein called compound interest "the greatest mathematical discovery of all time". We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.

The wonder of compounding (sometimes called "compound interest") transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset's reinvested earnings. To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.

Let us make a hypothetical situation about two individuals; Kofi and Ama. They were both 24 years old, and have just completed university. Kofi is a very cautious person. He does not want to start investing until he is ready. When he graduates from university, he made plans. He would learn about investment for several years and then start putting money aside after he is comfortable with investing. Kofi is also a fairly hard-working person. He would keep saving from the moment he invests until the moment he retires at age 65. As it turns out, Kofi finally take the plunge in investing at age 30; 6 years after he graduated. He diligently put $1,200, is aside a year ($100 each month) out of his meagre salary to invest. He continues doing this for 35 years until he reaches 65. Through ups and downs, Kofi manage to make a 10% return compounded annually.

Let's now consider Ama. Ama like Kofi is also a cautious person. But she is knowledgeable as well. She knows that investing in risk-free treasury bills could yield her 10% annual compounding return if history is any guide. So, fresh off university, Ama started putting money aside for investing. She invests $1,200 a year ($100 each month) just like Kofi out of her meagre salary. However, after reaching the age of 32, she decides that she wants to enjoy life quite a bit. She stops contributing her $1,200 is but rather uses it to fund her annual old school reunion party at her home.

Which one do you think would come ahead? Kofi who pours his whole heart into investing for 35 years and never stop saving until he retires at 65 years? Or Ama who invests immediately after school for 8 years into treasury bills and stops contributing after she is 32 years old?

Ready for the answer?
Wow! Ama who saves for a mere 8 years, manages to beat Kofi who set money aside each year for 35 years. What is happening here? Compounding is clearly working its magic here. By starting early, Ama has a huge head start of 6 years and she let compounding do its magic later on.

You think you can start saving now?
The message is clear. Start now and save as much as you can early. Are you a lazy person? I am. So, start early and you only have to invest for 8 years to get to the same result as your friend who start 6 years later and saves for 35 years. The faster you start, the better it is. The higher the amount you save early on, the more money you will have when you retire.

When you invest, always keep in mind that compounding amplifies the growth of your working money. Just like investing maximizes your earning potential, compounding maximizes the earning potential of your investments - but remember, because time and reinvesting make compounding work, you must keep your hands off the principal and earned interest.

Investing 101: What Is Investing - Part 2

Investing (n-vsting) The act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit. It's actually pretty simple: investing means putting your money to work for you. Essentially, it's a different way to think about how to make money. Growing up, most of us were taught that you can earn an income only by getting a job and working. And that's exactly what most of us do.

There's one big problem with this: if you want more money, you have to work more hours. However, there is a limit to how many hours a day we can work, not to mention the fact that having a bunch of money is no fun if we don't have the leisure time to enjoy it. You can't create a duplicate of yourself to increase your working time, so instead, you need to send an extension of yourself - your money - to work. That way, while you are putting in hours for your employer, or even mowing your lawn, sleeping, reading the paper or socializing with friends, you can also be earning money elsewhere.

Quite simply, making your money work for you maximizes your earning potential whether or not you receive a raise, decide to work overtime or look for a higher-paying job. There are many different ways you can go about making an investment. This includes putting money into stocks, bonds, mutual funds, or real estate (among many other things), or starting your own business. Sometimes people refer to these options as "investment vehicles," which is just another way of saying "a way to invest." Each of these vehicles has positives and negatives, which i'll discuss in a later post.

The point is that it doesn't matter which method you choose for investing your money, the goal is always to put your money to work so it earns you an additional profit. Even though this is a simple idea, it's the most important concept for you to understand.

What Investing Is Not
Investing is not gambling. Gambling is putting money at risk by betting on an uncertain outcome with the hope that you might win money. Part of the confusion between investing and gambling, however, may come from the way some people use investment vehicles. For example, it could be argued that buying a stock based on a "hot tip" you heard at the water cooler is essentially the same as placing a bet at a casino. True investing doesn't happen without some action on your part. A "real" investor does not simply throw his or her money at any random investment; he or she performs thorough analysis and commits capital only when there is a reasonable expectation of profit. Yes, there still is risk, and there are no guarantees, but investing is more than simply hoping that things will turn out well.

Why Bother Investing?
Obviously, everybody wants more money. It's pretty easy to understand that people invest because they want to increase their personal freedom, sense of security and ability to afford the things they want in life. However, investing is becoming more of a necessity. The days when everyone worked the same job for 30 years and then retired to a nice fat pension are gone. For average people, investing is not so much a helpful tool as the only way they can retire and maintain their present lifestyle. Whether you live in Ghana, the U.S., Canada, the UK or pretty much any other country in the world, governments are tightening their belts.

Almost without exception, the responsibility of planning for retirement is shifting away from the state and towards the individual. There is much debate over how safe our old-age pension programs will be over the next 20, 30 and 50 years. But why leave it to chance? By planning ahead you can ensure financial stability during your retirement. Now that you have a general idea of what investing is and why you should do it, it's time to learn about how investing lets you take advantage of one of the miracles of mathematics: compound interest.



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