The Smart Canadian Wealth-Builder: Chapter 13, The Magic of Compounding

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"Well, here we are again! Our fourth Saturday get-together. We're actually making good progress. So far we've discussed how to:

• Manage our cash spending;
• Control our debt, especially credit cards and mortgages;
• Save regularly;
• Utilize three key, tax-efficient savings vehicles -- the TFSA, the RRSP, and the RESP.

Today, as I promised you, we'll become familiar with several topics and terminology key to understanding future investment decisions which we'll be called upon to make throughout our lifetime."

"The first of these is the power of time and compound interest.

Kevin, have you any objection to our using your finances as an example? You might enjoy discussing your investments which with my advice, you've been accumulating since your early teens."

"Go for it, Grandpa," enthused Kevin.

"Great! In round numbers, I believe your present portfolio is worth about $5,000. Am I right?"

"Portfolio -- I kind of like the sound of that; it makes me feel like a successful businessman. But yes, according to my last statement, it was within a hundred dollars of that," replied Kevin.

"Wow! How did you manage to save so much, Kevin?" asked Jenny.

"Kevin's too modest to answer. It's mainly because his wants and needs are few. Up to now, he's been able to save far more of his allowance and part-time earnings than he has spent. He has shown an incredible degree of dedication to savings, which is most unusual not only for someone as young as he is, but for most of us at any age. Of course, we've been careful to invest his savings prudently, and they've grown significantly.

If Kevin is able to maintain this same discipline throughout his working life, he and his family will end up very wealthy indeed -- due in great part, to the magic power of compounding and time."

"We understand the basic concept of simple interest. But now let's understand what is meant by compounding interest when we use it in terms of investments.

Usually we are most interested in the compounded annual rate-of-return achieved on our investments over a set period of time. In simplest terms:

COMPOUNDING is a process by which the original value of an investment increases exponentially over time. As periodic dividends or interest are automatically reinvested, they escalate the dividends or interest earned in future.

Let's clarify this with an example. You have a $1,000 investment. It earns 5% interest annually. All interest earnings are reinvested. At the end of:

• Year One -- the investment has grown to $1,050
• Year Two -- the investment has grown to $1,103
• Year Three -- the investment has grown to $1,158
• Year Ten -- the investment has grown to $1,629
• Year Twenty -- the investment has grown to $2,653.

By contrast, had you chosen to not reinvest the interest earned each year and instead spent it, you would have been earning only simple interest on your $1,000.

By the end of year twenty you would have earned but withdrawn $1,000 in total interest payments. Compare this to the $1,623 interest which accumulated when you allowed the annual interest to compound. The magic of compounding earned you an extra $653 over 20 years."

"Maybe rabbits are nature's example of compounding," joked Jenny.

"The annual effect of this interest-on-interest growth doesn't at first, seem particularly significant; but as the definition states, it increases exponentially over time."

"Let's look at Kevin's current investment of $5,000.

Kevin, how much do you think you would end up with if, never touching the interest earned, nor adding to the original investment, you had invested this $5,000 at 5% annual and compounding interest, for a 40-year period?"

"I guess it could be worth over $10,000?" ventured Kevin.

"You'll both be shocked!

Invested today, at 5% compounding interest, for 40 years -- about the length of your working life, Kevin, your $5,000 would actually become worth approximately $35,000."

"No way! That's so awesome," exclaimed Kevin.

COMPOUND ANNUAL RATE-OF-RETURN is the percentage by which a given investment would need to increase each year, over a specified period, to reach a desired end value.

"So, if we were asked what the annual compound rate-of-return would be if Kevin's $5,000 increased to $35,000 after 40 years, our answer would be?"

"Five percent," promptly replied Jenny.

"Right you are! These two definitions are crucial to our understanding of the differing results we might achieve with various types of investments. But more on that later."

"For now, let me share with you some more compounding magic.

To keep it simple, we'll again use Kevin's $5,000 investment, the same 5% compounding interest yield, and the same 40-year term.

But we'll add another component -- an additional $200 monthly contribution to the original investment.

Kevin, would it be reasonable to assume, since you've managed as a teenager to achieve a $5,000 portfolio value, that once you have a full-time job, you should be able to add at least $200 a month to your initial $5,000?"

"Sure!" exclaimed Kevin. "That should be easy."

"Easy for some of us," muttered Jenny.

"If you were disciplined enough to actually do that, Kevin, and I've no doubt you will be, then your initial $5,000 investment would after 40 years, amount to an impressive $332,000!"

"Incredible!" exclaimed a stupefied Kevin.

"The actual cash you invested would have been:

• The initial $5,000, plus
• $200 monthly for 480 months, for an additional $96,000.

Your total combined investment would be $101,000.

That $101,000 would have mushroomed by another $231,000 due solely to the 5% annual interest earned on all invested contributions as well as all the extra interest earned on the reinvested interest. This is the magic of compounding."

"That's truly unbelievable!" declared a shocked Jenny. "It's like buying one Lamborghini, and getting two more for free!"

"I'm getting a kick out of throwing surprises at you two. Let's look at another scenario.

Let's assume that instead of investing your $5,000 in a fixed-interest instrument, you invested it in the Toronto Stock Exchange (TSX) Index. We'll also factor in the impact of your continuing to add $200 monthly to your initial investment.

The TSX Index produced an actual average annual rate-of-return over the years 1940 through 2007, of 10.6%. At this rate of return, your initial $5,000 over 40 years would become:

	Initial Investment	TSX Average Annual Yield (1940-2007)	Value After 40 Years
With No Additional Investment	$5,000	10.6%	$281,000
With Extra $200/Month Invested	$5,000	10.6%	$1,592,000

"Wow!" exclaimed Kevin. "That is some difference! All that extra benefit from only $200 a month of additional investment."

"Kevin, you are the only one I know who would say 'only' when referring to saving $200 every month!" teased Jenny.

"If you're impressed by that example, here's another which illustrates the startling effect of early-in-life investments on ultimate wealth accumulation. Let me start by introducing you to two lifelong friends, Jake and Larry.

Jake, at age 25, begins investing $400 a month. He's able to keep this up for 10 years, and then, at age 35, stops making further contributions. His investment averages a 7% annual return through those 10 years and continues to do so, until he retires at age 65.

His friend Larry also invests $400 monthly, earning the same 7% return. He however, is a few years older and only begins investing at age 35. He continues to invest the same amount monthly, for thirty years, until he retires at age 65.

Larry started investing at an older age than Jake. However he was diligent in keeping up his monthly contributions for the next 30 years, compared to Jake's relatively brief ten years of contributions.

Who do you think will have the larger portfolio at age 65?"

"Logic tells me that Larry, by investing the same monthly amount over a 30-year period instead of just ten years, should end up with the most money," offered Jenny.

"Well, Jenny, most people would agree with you.

Surprisingly, despite having contributed a total of only $48,000, Jake would end up with $521,000 at age 65.

Although Larry's monthly contributions would have totaled a much greater $148,800, he would end up at age 65, with only $468,000."

"How can that be, Grandpa?" asked Kevin. "Somehow it doesn't seem possible."

"The sole reason, Kevin, that Jake's investment grew so dramatically is that, despite his much shorter contribution period and smaller cash investment, his money not only compounded over the initial 10-year period during which he contributed, but then, the accumulated sum had a full 30 more years of compounded growth.

Larry on the other hand, had a total of only thirty years for compounding to work its magic. In other words, the effect was less dramatic than in Jake's case because Larry's accumulated savings and earned interest after ten years, had only 20 years of growth remaining, compared to Jake's 30 years.

Jake was able to contribute only one-third as much as Larry, but by starting ten years sooner, ended up with a larger nest-egg."

"Wow, I still can't believe it!" exclaimed Jenny.

TIP #37..... The combined magic of compounding, time, and self-discipline, can produce phenomenal results, especially for those whose saving and investing habit begins early in their working life.

"I'm beginning to understand how we can actually become millionaires by the time we retire," exclaimed Kevin. "But there's a slight problem. What I know about investing is basically zero."

"Don't worry about that, Kevin. You're not alone. Many of us lack this knowledge at first. Later in our chats, I'll describe investment products that will eliminate much of the mystery for both of you."

"What about inflation?" asked Jenny. "Forget the Lamborghini. What if forty years from now, Kevin can't even buy a basic clunker for the $1.6 million he might have accumulated in the example you just used?"

"That's stretching it a bit, but still a great question, Jenny! This is a really good time to understand the eroding power of inflation.

In terms of inflation's effect on all of us, it means that our dollar generally, will buy less in future than it does today.

If we say that inflation is running at 4% annually, we mean that the average cost of goods and services is expected to be about 4% higher than it was a year ago."

"So what do you think my almost $1.6 million in today's purchasing power, would be worth after forty years, Grandpa?" asked Kevin.

"To begin, I used 4% as an example because that was the actual average inflation rate that existed over the period 1940 to 2007 -- the same period that averaged 10.6% in stock market returns. If we were to apply the same 4% inflation rate to your 40-year investment horizon, we would find this sum of money to be worth about $330,000 in today's dollars."

"All those years of saving, investing, and planning, and that's all my efforts would be really worth?" exclaimed Kevin.

"Now you're beginning to see, Kevin. Because of the very real effect of inflation, targeting a one million-dollar retirement fund by the time you reach sixty, may be way too low a number, unless at that time you have other sources of income, like pensions.

Fortunately, in the last twenty years inflation in Canada has moderated greatly, averaging only 2.3% annually. Nevertheless, to be on the safe side in our calculations when trying to set your long-term investment goals, we may be smart to use a higher inflation figure of 3%.

Using this 3% rate of inflation over a 40-year period would make the $1.6 million worth about $485,000 in today's purchasing power."

TIP #38..... Because of the eroding effect of inflation on purchasing power, savers and investors must adjust their long-term objectives to compensate for inflation's drag on future values.

"So what you're saying, Grandpa, is that having $1.6 million today is a lot of money, but forty years from now, because of inflation, that amount may buy only the equivalent of what $485,000 will buy today?" queried Jenny.

"Assuming a 3% inflation rate, yes, that's correct, Jenny. It will still buy a lot, but not nearly as much as we might have wished for, or expected.

And we must take into account that eroding purchasing power, when we do a Financial Plan, later in our discussions."

"Does it now make sense why sheltering your growing investments as much as possible from income taxes becomes extremely important? Imagine if, in addition to the inflation drag we've just discussed, your investments were further eroded by taxes on increases in value!"

"I've heard people complain about the high taxes they pay, but this is the first time it's really hit home for me," observed Kevin.

TIP #39..... Protecting investment gains from income taxes is an extremely important element of every individual's wealth-creation strategy.

"The TFSA and RRSP savings and investment vehicles we discussed earlier are the primary tax-minimization tools available to every Canadian investor."

"I definitely get the importance of putting my money in a long-term savings plan, like an RRSP," agreed Jenny. "But the thought of investing in the stock market or something like that, makes me very, very nervous. It strikes me a bit like gambling. I've heard a lot of horror stories about people who've lost tons of money in the market."

"It's good that you're nervous about it, rather than flippant, Jenny. There's nothing wrong with wanting to invest more conservatively. But I think that a good part of your concern is based more on a lack of understanding. One can invest reasonably safely in the stock market, in a manner that greatly reduces risk, especially over the long term. I think our next discussion will help you with that.

It's also important to realize that any long-term investment plan needs to be balanced. The stock market is only one investment possibility. Our discussion on various investment options will I think, make you feel more comfortable."

UNIQUELY CANADIAN -- A PRACTICAL STEP-BY-STEP GUIDE TO WEALTH-CREATION

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