Source: Contrarian Living
You do know the mathematical formula of compounding. But do you also understand the non-linearity of compounding?
If we want to create wealth over the long term, we need to fulfill three important criteria –
- Living a very long life.
- Uninterrupted compounding for decades.
- Frguality.
Take the example of Ronald Read. He was a resident of Brattleboro who died at the age of 92. He worked at a gas station for most of his life but still managed to die with a net-worth of $8 million. What worked for him? Remarkable frugality, decades of compounding, and living till the age of 92.
Frugality has to be a constant irrespective of our income levels. Instant gratification in our generation is at it’s peak. We spend anywhere between four to six hours everyday on our phones. Social media and online retailing has made it easy to spend money after a few clicks. Shopping was never easier. Saving money is last of our priorities.
Forget wealth creation, our generation is reeling under retail debt. We do not like waiting. We bury ourselves with debt at the first instant possibility. A retirement case study in India by HSBC found that while 76 percent of working age people in India expected a comfortable retirement, only 33% of those were actually putting aside money to retire. 68% respondents in the study said that they would rely on their children to provide for their retirement.
Depending on your children is the last thing you want to do in your retirement. While I believe it is not morally correct to depend on your children, thinking that your children will support you is having unrealistic expectations from them which may not come true. There are thousands of old age homes filled for a reason.
It is our responsibility to provide a good upbringing to our children. It is also our responsibility to provide for our own financial independence.
“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things” Charlie Munger
At the beginning of the article, I said that compounding is non-linear, what did I mean by that?
Let’s take a simple example. If you started investing at the age of 20 with INR 10,000 every month and invested the same amount every month for forty years till the standard retirement age of sixty. In the second instance, let’s take the example of your friend who starts investing INR 20,000 every month from the age of 30 and invests till the age of 60. Both of you compound your money at 10% per annum.
Aren’t the results mind-blowing? Not only your principle outgo is lesser, you also end up with more money at retirement. The more time you give to compounding, the better your results could be. You do not have to start withdrawing at the age of 60. You can continue to work as long as you enjoy working and quit only when you want to.
“Compounding matters and does so far more than people expect. The human brain thinks in a linear way which means that if we were asked to estimate what 10.22% compounded over 100 years would be then our answer is likely to be closer to 1,022% than 1,679,600%, something economists call exponential growth bias. This means that compounding is often underestimated and should be at the heart of long-term investing” Marathon Asset Management
What Are Some Strategies That Could Be Used To Start Early?
- From the day you start making money, start putting aside some money in index funds. Starting with a small contribution of 5% to 10% of your overall earnings will take you a long way.
- Invest before you spend, not the other way round.
- Don’t fall in the “get rich quick” trap. Blindly avoid all strategies that promise you quick returns. Everything is a scam.
- Practice frugality. Live a balanced life.
- Play the long game. Make volatility your friend.
Compounding takes time. The returns are back ended. You need to be the tortoise on the road to financial freedom. It’s a long and lonely journey. But the probability of you ending up wealthy in this journey is extremely high.