In this post I'm going to revisit Compound Interest. It makes all the difference in the investment world.
With a working knowledge of compound interest, all you'll need to become very rich is just lots of time and no [very] bad luck (you don't even need good luck). And I'm telling the unvarnished truth.
Compound interest is when your interest generates interest. When every naira you gain works as hard as your initial investment, to make you another naira. And it's the most profitable knowledge in the world of finance, if used right.
If I invest N1,000,000 at a simple interest of 10%, after 20 years I'll have N3,000,000.
If I invest the same N1,000,000 at a compound interest of 10% for 20 years. I'll have N6,727,500.
The difference is a whooping N3,727,500!
How do I apply that in my day to day investment life?
If I'm to pick between a 10 year FGN bond with a coupon rate of 15% and a face value of N1,000 selling at par (at par means at full face value, in this case, N1,000); and GTB shares at N25 per share, dividend rate of 7% and dividend growth rate of 10%. It's only the understanding of compound interest that will enable me make a good comparison.
N1,000,000 invested in the FGN bond will equal N1,000,000 gotten when the bond matures in 10 years + N150,000 paid to me every year for 10 years. Totaling N2,500,000. The interest I get is simple interest.
If I invest the same N1,000,000 in GTB shares at N25 per share. I will get dividends worth N1,274,994 in the same 10 year period. And if GTB shares are still selling at same N25 after 10 years. My total cash flow on sale of the shares will be N2,274,994.
As you can see, I'm able to translate the two different investment opportunities into numbers I can compare more reasonably because I understand compound interest.
In this case, I know that investing the N1,000,000 in GTB makes the better sense. GTB has a market beta of less than 1. It will take an unprecedented catastrophe to make the share price remain at N25 after 10 years. And I have used highly conservative assumptions. GTB's actual dividend growth rate has been more than double the rate I used in this example. Though, I'll incur more transaction costs in buying and cashing out of the GTB shares than FGN bonds, it's insignificant compared to the sure part of the gain in sight.
Now that's fairly complex. But that's how it works in reality. Nearly everything builds on your working knowledge of compound interest.
A working knowledge of compound interest is very vital. Whenever you are presented with an investment opportunity, the first question you should have answered is whether the returns are in any way compounded or not.
If I'm to pick between a quarry business and a pure water business. I'll be less excited about the quarry business. The quarry has a fixed output (like the FGN 10 year bonds), I can't increase the absolute output by reinvesting my earnings into the business. It's like a simple interest investment.
But I can easily increase the quantity of pure water I pack (for almost forever) by reinvesting my earnings in the business. This is the business version of compound interest. But it's often referred to as scaling. Ability to increase your turnover without having to start from scratch [again].
Finally, compound interest changes the way you think. It makes you understand the time value of money. I prefer calling it the money value of time. All you need to become a millionaire is not a huge salary someday, it's prudent investment today. Because with compound interest, N100,000 becomes N1,000,000 in few years if you find great investments.