The Magic of Compounding

If you don’t earn much and can barely pay your expenses, the idea of saving is ludicrous as just saving $30 or 1% of your monthly income may seem small and irrelevant. The old me would rather indulge in a good meal at Chomp Chomp than to save it in my piggy bank. Why would I even bother?

Because Rome wasn’t built in a day.

Everyone, including myself, has to start somewhere. Small pieces of bricks put together will eventually form a fortress. Our financial situation will improve over time and even the smallest amount of savings will definitely benefit us over the long run. This is largely due to the power of compounding.

Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods. Compounding, therefore, differs from linear growth, where only the principal earns interest each period. -Investopedia

The Math Behind Compounding

Power of compounding proves that time is our greatest asset when it comes to building wealth. Here’s the mathematical breakdown on a fixed deposit account.

Formula (1)

For illustration purposes, let’s take $100,000 initial deposit with 5% annual interest and compare the differences between saving it for 5 to 40 years.

Screenshot_3 (2)

From the graph above, it’s shown that the 5-year growth increases with the number of years deposited, causing an exponential effect. This proves that the longer you let your money compound, the better. Which is why investors always like to say:

Time in the market is better than timing the market.

However, the above formula represents interest compounding at a continuous rate. Realistically speaking, interest doesn’t compound every day and second. A high interest savings account such as DBS multiplier compounds every month while an endowment plan offered by banks or insurance companies compounds 1-2 times a year. To put it into simple terms, the more times the interest money is credited annually, the better. A 2.5% interest savings account that credits twice a year is better than a 2.5% interest savings account that credits annually. So do remember this when you are considering two or more saving plans at similar interest rates!

Effect of increased compounding periods per year

interest (1).png

As you can see, having interest credited twice a year is definitely beneficial. Although the returns are small and negligible during the first few years, they could really ramp up over the long run and this difference would mean having an extra holiday with your family or not!

The actual formula for compounding is shown below:

FV = PV * [1 + (i / n)] (n * t), where:

  • FV = future value
  • PV = present value
  • i = the annual interest rate
  • n = the number of compounding periods per year
  • t = the number of years

Case study

Now that you know compounding is basically earning interest on interests and time is our greatest friend, let’s take a look at a typical scenario.

Johnathan and Mike have the same retirement goal of wanting to retire at 65 with $1,000,000. They both, however, led very different lifestyles. Johnathan is a smart saver and started saving $500 every month since the age of 25. Mike led an active lifestyle and was willing to double Johnathan’s savings when he hit 40 to compensate the loss in savings during his mid-20s. They both put their money in a portfolio which compounds yearly with an average return of 7%. Let’s take a look at their retirement accounts at 65.

mike vs johnathan (1)

Annual addition Years to grow Interest rate Compound
$6,000 Johnathan: 41 Mike: 26 7% 1 time annually
Total amount invested ($) Final amount ($)
Mike 312,000 881,806
Johnathan 246,000 1,377,793
Difference 66,000 -495,988
% Difference Mike invested 27% more Mike had 35% less

You must be wondering, how did Mike end up with 36% (496k) lesser than Johnathan despite saving 27% more? Ladies and gentlemen, this is the power of compounding! At 7% interest rate, taking the rule of 72, it takes roughly 10 years to double his capital. $6,000 would turn into $12,000, then $24,000 then $48,000 and finally $96,000 over 10, 20, 30 and 40 years. It was the final 1-2 doubles that really mattered and widened the gap between Johnathan and Mike.

“I’ll start saving next year”

Sounds familiar? Although there is little harm by delaying a few years, we could miss out on great returns the later we start. Here’s the graph showing Johnathan’s returns should he start at ages 25, 26, 27, 28 and 29.

savings at different age (2)

Age 25 to 26 26 to 27 27 to 28 28 to 29 Average
Difference ($) 96,136 89,847 83,969 78,476
Difference (%) 93.02% 92.99% 92.95% 92.92% 92.97%

On average, every year Johnathan delays reduces his potential returns by ~7%. Of course, this is not meant to scare any of you, but I hope these figures and graphs show you the importance of starting today. When people start to save, it often seems slow and pointless because things don’t change overnight. But as time passes, the rate of absolute change gets faster and faster and this is why the power of compounding is magical.

Before I finish, I would like to highlight that albeit the advantages of starting early, we should’t have a one-track mind and only focus on growing our wealth. If you’re like me and enjoy spending on movies, concerts and cafes, you don’t have to overly sacrifice your lifestyle just to lead the ‘suffer now, enjoy later’ life. Remember, progress is best made in a moderate and sustainable manner.

The future is unpredictable, so we should find a good balance between saving and spending. The best way is to set a goal and live within our budgets. I’ve covered this in my previous article: The Newbie’s Guide to Budgeting.

Lastly, if you don’t know how to find consistent returns on your savings and investments, my suggestion is to talk to your trusted financial adviser. I’m a huge fan of diversification and although I prefer to manage my own portfolio, I also feel the need to allocate a portion of my savings in a high growth investment plan. This protects me from the risk of losing all my savings if my investments were to turn ugly. If you are looking for an agent that comes from an investment banking background and managed to bring consistent returns for his clients, you may contact me at thefivelayers@gmail.com and I’ll link you up with him. Thank you for reading and happy building your layers.

The video below summarizes this article in two minutes.

*Featured image from Business insider

Continue reading “The Magic of Compounding”

Here’s how you can be a real life Crazy Rich Asian.

Dreaming to be a Crazy Rich Asian? Stop dreaming and start making it a reality. While most of my friends and colleagues are spending their time making a fuss about the high costs of living in Singapore, the wealthy have already planned their steps ahead. We may not be rich or crazy rich now, but with proper planning and execution, it certainly isn’t impossible.

First things first, we must define what being rich or crazy rich is. To me, being financially free is considered rich. Being financially free and able to afford branded goods is crazy rich.

This article will introduce the concept of The Five Layers, how to retire comfortably in Singapore and finally, being crazy rich.

Assumptions include:

  • Retiring at 65
  • Expenses at $3000/month equivalent to $36,000/year

1. Central Provident Fund (CPF)

For majority of us Singaporeans and Permanent Residents, whether we like it or not, CPF is mandatory. It is a social security system that requires both the employer and employee to contribute a certain amount for retirement, property and healthcare.

CPF

*Image taken from CPF website

Fun fact: Do you know your CPF account returns you an interest rate of up to 5% annually? Taking the rule of 72, it will take 14.4 years to double your amount!

Assuming we meet the Full Retirement Sum, we will be receiving a monthly payout of $1400/month starting 65 years old, almost half of the target of $3000! I will be sharing more about the tips and tricks to maximizing our CPF accounts in future posts.

2. Savings

There are two types of savings:

2.1 Saving money from budgeting and stretching your dollar.

Before we start saving, we should aim to be debt free first. That includes paying for our credit card loans and student loans because the interest rate from the banks could really hurt overtime.

interest

Assuming you took a student loan of $40,000 at 4.88% interest and the minimum monthly instalment is $400 every month, it will take 10 years to clear your student debts and you would have paid a total of ~$50,000. That’s a loss of $10,000! This is why financial experts usually advise people to first pay off their debts before investing.

Budgeting is important. Pay yourself first. By that I mean allocating a specific amount into your savings account once you receive your paycheck to clear your debts. I will be writing on how to allocate our money using a very simple strategy. Different ways and tools you can use to allocate and track your expenses. And if you are feeling adventurous enough, you may wish to follow my way of optimizing my budgets.

2.2 Saving by putting money in a savings account.

Savings-Account-2

*Image taken from Seedly.

Nothing beats the old fashion way of saving money by putting it in a bank account. But why put it in an ordinary savings account returning 0.05% interest when you should be getting 1% at the very minimum?

However, most banks require us to use their services such as crediting our salary, signing up for credit cards and meeting the minimum spend etc before we can enjoy these interest rates.

Let me ask you this question: How much are you saving if you were to spend $70 on a $100 item? The obvious answer is $30. But in actual fact, you just lost $70 because this amount could be saved for the future!

This is how minimum card spend works. So one might spend a few hundred dollars more on items or services they don’t need just to be eligible for credit cards cashback and monthly savings account interest.

I’m not discouraging credit cards. In fact, I have 3 credit cards because they are essential tools to help me maximize my savings. I will be writing on why I decide to make this decision and show you how powerful these cards can be when used correctly.

I will also be sharing my strategy to maximize my savings account and different ways you can approach based on your spending habits.

3. Long term investments

Unfortunately for 41% of Singaporeans, their wealth journey ends at point 2. So unless we can guarantee $384,000 in our account by 65, we will never hit the target sum of $3000/month (CPF+Savings). Not to mention that value is less inflation. The graph below shows a simple illustration on how much $384,000 is worth after 20 years.

inflation

With the average inflation rate in Singapore being 2.6%, the equivalent value of $384,000 would only be $226,730 at the end of 20 years. That means we can buy less things with $3000 after inflation. In fact, the true value would be around $2344 after 20 years.

Realistically speaking, unless the bank account we are using is able to equal the rate of inflation, the value of $3000/month will depreciate over time. Thus, we invest to beat inflation.

But but! Investment is risky and I might end up losing money instead!

Well, here’s another fun fact: Investing is only risky when you don’t know what you are doing.

spy2

*S&P 500 Index

If you purchased the S&P 500 index since its beginning in 1993, you would have made 537% returns today (August 2018), over a period of 25 years. That is about an annual return of 13.4%, beating inflation by more than 5 times every year! Before you get your hopes up, we must note that past performance is not indicative of future results, a more realistic expectation would be around 8% and I will share with you readers why in the near future.

As someone that only started investing this year, I do not have the wisdom and experience equivalent to the seasoned investors out there. However, there are really simple investing strategies which are almost guaranteed (99%) to beat inflation only on one condition: We must invest for the long term.

ssb-pdt.png

Those who have upcoming big ticket purchases (renovation, kids’ education fees etc) and are unable to hold their positions in the stock market for long may consider getting bonds which almost guarantees a return of 1.75-2.97%.

SSB.JPG

*Image from SGS (September’s 2018 bond)

With proper planning and execution, I’m confident that the first 3 layers are sufficient for an average Singaporean to retire comfortably.

4. Passive Income

Remember I talked about being a Crazy Rich Asian? Passive income is what separates the crazy rich from the middle-income. According to Wikipedia, passive income is defined as income resulting from cash flow received on a regular basis, requiring minimal to no effort by the recipient to maintain it.

I highly recommend the book “Rich Dad Poor Dad” by Robert Kiyosaki. It talks about managing our cash flow and finding assets that generate money. If you are too lazy to read, below is a summary of the entire book. And if you haven’t noticed, all the rich people have one thing in common: They all belong to the right side of the quadrant. Nick Young’s family owns many real estates. So yeah…you get the idea.

RDPD.png

*Image from The Norells

As the saying goes: “The rich gets richer, the poor gets poorer.” This is true because the rich are “Financial Free” as their passive income has surpassed their expenses. With that monetary security, they are not living life to make money. They are free to do what they want such as pursuing their photography or writing passion, traveling around the world, etc. Literally anything they want. For most crazy rich people, they would buy more real estates or start another business with the extra income they earn and in return, it increases their passive income. See below for a simple illustration.

RR (1)

Realistically speaking, if you are just like me and have just started working, we shouldn’t be looking into businesses and real estate now. Not until at least we have saved enough emergency funds, be debt free and have a consistent amount of savings each month into our future goals account (BTO, Marriage, Kids education etc).

However, time is our greatest asset. We should aim to invest our time to learn new skills that improve our lives. If you have a particular skill or passion that is high in demand (Writing, design etc), you may want to consider doing freelance to earn additional income. I myself will be looking at taking advanced Microsoft excel course to improve my efficiency at work. To help you better understand, here’s a story.

WOW (2).jpg

That’s the power of investing our time in things that bring value to us.

Did you know? If you are a Singaporean aged 25 and above, you are given $500 skillsfuture credit where you can sign up for approved courses to upgrade yourself? What’s best is most courses don’t cost much and you can enroll in them for free!

5. Trading

This is what I call the cherry on top of the cake.  A trader typically works 1-2 hours a day and on average, they earn about 20% of their revenue PER MONTH. But trading isn’t easy and comes with great risk. According to statistics, only 8% of traders are successful.  Speaking from someone that has tried trading, it requires discipline, consistency and most importantly of all, control of emotions. One may win 9 trades in a row but if he gets greedy on the 10th, he may lose all his earnings. Trading isn’t a one month or one year thing. You need to have a decent trading strategy, hopefully one that gives you a statistical advantage and stick with it. If you read about the law of averages, it states the supposed principle that future events are likely to turn out so that they balance any past deviation from a presumed average (Wikipedia). Eventually, your win/loss ratio will average out and you will start earning money. This is why casinos always make money no matter how much people play.

A simple rule: Don’t trade what you can’t afford to lose. If you think reading and watching online videos aren’t enough, there are many live workshops available.

Being a Crazy Rich Asian isn’t for everyone. But if you are willing to invest your time and money, it isn’t impossible to build your fourth and fifth layers. The road will not be smooth like butter. Expect to fail but more importantly, learn from your mistakes and don’t repeat it.

Lastly, thank you for taking the time to read my first article. If you’ve enjoyed it, please share it around. You may find me on Instagram, Facebook and Medium as well. I’ll continue to write more articles starting from where I began my Five Layers journey and hopefully, you will be able to follow my journey and start building your layers as well. If you need help to kick start your financial journey, please feel free to contact me. I’ll reply when I can.

Once again, thank you for reading and happy building your layers.

*Featured Image from Warner Bros