The Most Powerful Concept In Financemarcuss
My friend and former colleague, veteran investor Peter Churchouse tells a story with a great lesson about the most important concept in finance.
Here it is in Peter’s own words:
Not long ago, I bought a 10-year old Jaguar in Hong Kong, where I live. I paid roughly US$6,500 for it…
The first owner paid roughly US$100,000 for this car, back in 2005. So I paid nearly 94 percent less than the original purchase price. The return on investment of the car for the original buyer works out to negative 23.7 percent per annum, on an annualised basis (and that’s ignoring every other cost associated with running the car).
Buying a new car – in high-priced Hong Kong or anywhere else – is almost always a terrible investment. Depreciation from the second you drive it off the lot is the name of the game.
However, here’s the other side of this story. In early 2006 – that is, a few months after the original car owner in question bought his Jag – I purchased a small investment property in Hong Kong. I paid approximately US$180,000 for a little one-bedroom walk-up flat in Central, Hong Kong.
I took out a 50 percent mortgage to buy it, so my down payment after stamp duties, agents’ fees and other expenses was roughly US$100,000. I could have bought myself that brand new 2005 Jaguar – but instead, I bought a flat in need of some tender loving care.
Fast forward to 2015. After a good run, I sold the apartment for US$943,000. That’s a return of close to 950 percent on invested capital – in about 10 years.
A 94 percent loss, with the Jag… vs a 950 percent gain, in real estate. That can be a life-changing difference.
My point is that the next time you see a young person (and it’s almost always a man) behind the wheel of a fancy automobile, ponder his investment decision. Of course, we’re all grown ups and can do what we like with our money (my personal financial vice is my boat!). If fast cars and fancy watches are your thing, fine. But I can’t help but wonder if some people wouldn’t be doing themselves a favour by just leaving the Jag – or similarly pricey bauble – in the showroom.
Peter is referring to a few different financial principles here… most notably, opportunity cost: That is, the price you’re paying by not doing something else with your money. Buying the Jaguar off the lot would have carried a far higher price tag than just the cost of the car… it would have also represented the cost of buying a small apartment that would up making a 950 percent return.
The power of compounding – over long periods of time
Another side of letting money do its job is the power of compounding: The very same concept that Albert Einstein is said to have called “the greatest mathematical discovery of all time”. And it’s probably helped more people – along with careful consideration of opportunity cost – build wealth than all the other investment strategies in the world put together.
Compounding is a simple idea… in short, it means reinvesting returns instead of spending them. Over time, the original investment gets bigger and bigger as more returns are reinvested.
It’s like a snowball rolling down a hill. The further it rolls… the bigger it gets.
For example, if I invest US$10,000 with an annual interest rate of 5 percent… after 12 months I’d get US$500 in interest. But instead of spending that US$500, I reinvest it on the same terms… now I’m earning 5 percent on US$10,500. So 12 months later I’d get US$525 in interest, which I again reinvest… and on it goes.
Just like a snowball, the investment is getting bigger every year. And I’m earning interest on top of interest.
In the short term, that doesn’t sound like a lot. But now look at the magic of compounding over several decades… and the more decades, the better.
If I started investing when I was 25 years old with an annual investment of US$20,000 (and I reinvested the interest each time) at 65, I’d be sitting on a nest egg of about US$2.5 million.
But if instead I’d started investing the same sum each year, on the same terms, at 35 (rather than 25), I’d have about US$1.1 million less when I retired – because compounding has had less time to work its magic, as the graph below shows. That’s a huge difference.
So when it comes to compounding… time is the secret to success. Starting as soon as possible and reinvesting interest over several decades can build life-changing wealth.
Publisher, Stansberry Churchouse Research
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