Power of compounding and a math of 15 year old – Coffee with Abhishek

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I will start with saying that, knowledge is true wealth to succeed in life. Getting a quality education and a job that we like is very important in the beginning. Once we start a job and have a salary, the first and foremost rule to become rich is – to spend less than what we earn. If we follow this rule for life, we will never run out of money. Now, becoming rich doesn’t necessarily mean staying frugal and just keep on saving money. We must invest that money, i.e let that asset generate more earnings for us over a period of time. Large wealth can be built if we understand the law of compounding and learn how to apply it. Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings.

Bear with me while I try my best to explain this. The rule of 72 is an estimate of a number of years required to double the money at a given annual rate of return. For example, if we put $5,000 in the tax-deferred account (ROTH IRA, 401K, EPF or PPF), and it earns 15% returns annually, then 72/15 is approximately 5, i.e our investment will double every 5 years. If we were to invest $5,000 for next 50 years, our money is going to be doubled 10 times (i.e 2 to the power of 10 which is 1024). Let’s make the math simple here and multiply $5,000 by 1000 which becomes whopping $5 Million! Wasn’t that a math of 15 years old?

Power of compounding
Notice the exponential growth of money from 40 to 50 year period.

There are total 3 variables we can play with. One, the more we save the higher the reward will be. We get $5 Million in 50 years if we save $5,000 today, vs. $1 Million over the same period if we save $1,000 today, assuming everything else remains the same in the example above. Second is time, the longer we remain invested, the higher the returns will be. $5,000 at 15% become $1.28 Million at the end of 40 years but $5 Million at the end of 50 years. Notice the exponential growth of money from 40 to 50 year period in the above chart. Third comes the rate of return, i.e 24% rate of return doubles our money in just 3 years (72/24 =3) vs. 15% rate of return which doubles in 5 years. Is 24% annual return even possible? Maybe. If we had invested $10,000 in Berkshire Hathaway in 1965, it would have been close to $88 Million with 20% annual return compounded.

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Taxes & Inflation

Inflation and long-term taxes are two scissors which cut our investment returns. Inflation is inevitable, but taxes can be controlled by staying invested over a long period of time. Investing through tax-deferred account requires us to remain invested until we turn 59 ½.  Similarly, investing via employee provident fund (EPF) in India is tax-deferred until the age of 55. Average annual inflation in the US has been around 3-4% and long-term tax is 15%. Same has been around 5-6% and 10% respectively in India. This may lower our returns by a little yet, it’s a great reward for doing almost close to nothing.

The easiest thing for anyone is to consistently save and invest in compounding engines that reward good returns. Tax-deferred accounts should be the first choice. Fixed deposit in India gives assured 7-8% annual return. Investing in the stock market through index funds like S&P 500, Russell 2000 or Nifty 50 could give annual returns of approximately 10-11%. Good mutual funds in India have historically delivered 15-20% returns annually after management fees. Note, it is important to remember that our net returns are returns minus inflation, i.e if we earned 15% annual return on our investment in 3 years and the inflation is 3%, we gained net 12% minus taxes. This is why keeping cash in the savings account is not recommended as inflation reduces the value of that money over a period of time.

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Investing is all about reading, learning, and patience.

Monthly budgeting can help us save as much as 50% of our monthly salary. Check out Mr.MoneyMustache. It has great material on different ideas for budgeting and is also a great resource for investing. Getting a consistently high rate of return on our investment is where the hard work comes into the picture. Per Warren Buffett’s teacher – Ben Graham, ‘the expected rate of return depends on the amount of effort we are willing to put into an investment’. This throws a lot of people off who have no interest in investments. I get it. It’s not for everyone, and even 80% of money managers can’t outperform the market. Thus, passive investing i.e. consistently buying index funds via tax-deferred account is a great approach to become wealthy over time. Time plays a vital role in investing as explained earlier.

I wanted to dig deeper on how we can get a higher rate of return. After reading few books and watching a bunch of videos about Charlie Munger, Warren Buffett, and Mohnish Pabrai, I realized that investing in public companies should be thought of as owning a part of the business rather than just as a shareholder. Warren Buffett and Charlie Munger are great business owners, but they do not necessarily manage most of their businesses (approx. 64). I have always been curious about different businesses and that’s how I decided to learn more about investing. Berkshire Hathway’s shareholder’s letters is a great resource which is completely free online. Warren himself writes these letters and explains different concepts in a much simpler way.

One of the most common and important aspects of all value investors is that they all are a learning machine. Warren & Charlie spend more than 65% of their time reading different books. The biggest reason for me to start a blog is to evaluate different businesses, share different ideas with the investing community, and learn more from others. 

PS:- This is my first ever blog post. Any comments are much appreciated.

Sources & Credits 
Mohnish Pabrai
Companies owned by Berkshire Hathaway
Average Annual Inflation (US)
Berkshire Hathaway returns since 1965

 

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Abhishek Shete
Abhishek is a novice in investment. His write-ups help him separate facts from the perception which improves his knowledge. He enjoys reading about businesses, business models, playing badminton, poker, and cricket. On top of that, he is an ardent coffee lover.
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