I once received an e-mail from a reader of my blog who wanted to know how much he would earn if he invested 10,000 cedis in treasury bills for 3 months. Questions like this always make me nervous. From experience, people who ask these questions about investments on such a short-term basis expect answers which would suggest that it would be possible to reap a significant return in a short-term. Unfortunately, most investments do not work that way.
In the world of finance there are few people who are more respected than Warren Buffett. The man nicknamed the Oracle of Omaha is the third wealthiest person on earth with a net worth of 91 billion dollars. In fact, his name is so synonymous with the word billionaire that one would be surprised to learn that he did not become a billionaire until he was a few months from 60 years old.
Just think about that for a minute. The man is 88 years old and for almost 70% of his time on earth he was not a billionaire. Since he became a billionaire though he has added a mind-boggling 90 billion dollars more in net worth. Now let us do a little bit of math with the assumption that he was born with exactly zero dollars, and let’s also ignore inflation. Warren Buffett would have added an average of 16.7 million dollars to his net worth every year in the first 60 years of his life. He however would have added an average of 3.2 billion dollars a year to his net worth since then. The lesson here is that although it took him quite some time to reach a billion, his wealth grew by a ridiculous multiple after.
In most places in the world, the age of 60 is when people get ready to wrap things up with work and head to a well-deserved retirement. Many young people expect that by the time they get to 60, they would have already been swimming in wealth but unfortunately that is not realistic. The truth of the matter is that building significant wealth takes a very long time and people who place that goal at the top of their investment objective are going to have to be patient.
The Power of Compounding
I mean, Warren Buffet says it himself. Over the years he has attributed his wealth to the wonderful effects of compound interest. If you invest a small amount of money in an investment paying compound interest for long enough, it will eventually become a large amount. Let’s go back to the question I referred to at the start of this post. 10,000 cedis invested in 91-day t-bills for 3 months will turn into 10,325 cedis at the current interest rate of about 13%. However, if you were to invest that same amount in the same investment for 30 years, it would be worth 464,309.15 cedis.
Let’s try to put the importance of compound interest into perspective. The best way to do that is to compare it to a much simpler concept – simple interest. Assuming I were to lend you 1,000 cedis at a simple interest of 10% per annum for 10 years, you would have paid a total of 1,000 cedis to me in interest as well as my principal of 1,000 at the end of the agreed period. This is easy to calculate: 10% of 1,000 each year would be 100. For a total of 10 years that would amount to 1,000 cedis.
Now assume I had lent you the money with a compound interest of 10% per annum instead. After 10 years you would have to pay 1,593.74 cedis in interest as well as the principal of 1,000 cedis. Compound interest therefore results in you having to pay over 59% more in interest to me than you would have had to pay if I had charged you a simple interest on the loan. The reason for the disparity is that while simple interest only calculates interest on your principal, compound interest calculates interest on your principal as well as any accumulated interest over the period. With this mechanism, one can generate a significant return on even small amounts of money as long as the time scale is long enough.
But t-bills are not the only investment. There are fixed deposits, mutual funds, real estate funds, stocks and so on that one can invest in. I am only using t-bills as an example because of the predictability of their returns. But the importance of compound interest is not diminished no matter the investment type that one chooses. After all, Warren Buffett made his money in stocks and it is the compounding effect of annual returns on stocks that he probably meant when he was discussing compound interest.
Patience, I know, is not the easiest virtue to cultivate. We have had several examples in Ghana of finance firms which offered the kind of get-rich-quick returns which many investors have been dreaming of only for them to collapse with devastating consequences for people who deposited money in them. The idea of many people who fall victim to these schemes is that an investment, no matter how small the capital, should be able to generate income for living expenses. This is why they seek returns of anywhere from 50-100% a year.
But I do not think that is how one should look at investment income. It is only when you have accumulated enough capital that you can reasonably expect to be earning enough returns from your investment to be able to live off investment income. It is much more realistic that our living expenses come from business or employment. Compounding cannot work if we take the returns off the investment and leave only the capital. The compounding effect requires that we invest the returns of one period so that the returns of the next period would be calculated on both capital and accumulated returns.
A Marathon not a Sprint
A popular saying among the finance community is that investment is a marathon not a sprint. Short term investing is fine if you spot a quick opportunity to make a return. Sadly, that is not what happens a lot of the time. In most cases the success of an investment depends on carefully selecting an investment with proven security, contributing religiously to it and sticking through periods of poor returns. It is such a long and tiring experience that not everybody will be able to do it. That is exactly like a marathon. Not everyone can run a marathon.
Warren Buffett is famous for investing in only businesses he understands. A combination of simple but solid investment decisions and a long investment horizon has made him a roaring success. In fact not only is he an advocate of the simple, he is also a skeptic of the complicated. Last year he won a $1 million bet that simply buying an index fund to track the performance of the S&P 500 will outperform the returns of a collection of hedge funds over 10 years. This simple exposure to the broad stock market resulted in an average gain of 7.1% a year while the hedge funds only returned an average of 2.2%.
If you are on this website and you are not looking for a loan, my assumption is that you are looking for an investment. My suggestion is that you think of the long-term as you pick your investment. Do not expect that you will strike it rich immediately. But know that with careful planning and a commitment to your plan, you will eventually achieve your investment goals.
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About Jerome Kuseh
Jerome Kuseh loves to learn about investing. He started his blog, ceditalk.com, as a way to share what he had learned with a wider audience. He is an accountant by profession, with a degree in accounting from UPSA and an ICAG qualification. Jerome is also an MSc Economics candidate at KNUST. You can reach him via jerome[at]ceditalk[dot]com as he is happy to take any questions you may have.