I have always harped on why the rate of interest and the tenure are the two most critical factors to make the law of compounding be a major friend for you.
In India we have had a lock down for the last 3 weeks. So we are all working from home. But on weekends, because there’s no place to visit or friends to meet, we are getting a lot more time to do research. On one of these research journeys a few days back I was reading about the Hemchandra – Fibonacci series.
It seems about 3000 – 4000 years ago when there was very little written text as a medium of transfer of knowledge, Indian sages used to build the scriptures in such a way that there was scientific pattern so that the texts were rhythmic and easier to learn.
So what’s the series – we will not go into the mathematical part of the background – but concise to say that it defines any number to be the sum of the immediately preceding two numbers. So if your first number is 1 and the second number is also 1 then the third number will be (1+1) meaning 2. The fourth will be the summation of the 3rd number and the second number (2+1) equaling 3. The fifth will be summation of 4th plus 3rd (3+2) equalling 5. Now starts the interesting part the sixth number is fifth plus fourth (5+3) equals 8 and the 7th number is (8+5) equaling 13…..see the image above
This rattled my mind completely. Which brings me back to the introduction. I had always stressed that starting early even with a small amount and being invested over a long term are the basis of wealth creation. Which meant that those who started late in life on this journey could not benefit from the “number of years” part of the equation.
But understanding this sequence changed everything…..to explain this let’s make a few assumption. For comparison we assume that the first person starts at age 25 while the second one starts at age 40. Let’s call the first person Anil and the second Tom.
Now Anil starts investing USD(or Rupee) 500 per annum from age 25 till age 57 at a rate of interest of 15%. At age 60 he will have a corpus of USD(or Rupee) USD (or Rupee) 505436 while he would have put in only USD (or Rupee)16500 (500*33 years), the compounding would have created the magic to turn this into such a large sum. This is what I have been harping over the last few years to everyone who is even willing to give me half an ear of attention. Even with small amounts if you start early you can become wealthy because of compounding.
Now comes the interesting part. Suppose you are in your mid 30s or early forties, you can still make a similar or larger amount of corpus for yourself if you follow the Hemchandra-Fibonacci concept.
At age 40, Tom starts with investing USD 500(Rupee) in the first year at the interest rate of 15%. He has the same agenda to have a corpus by age 60 and invests till age 57. In the second year he again invests USD (or Rupees) 500. In the third year following the principle he adds the first 2 years investments and invests USD 1000/-. In the fourth year he invests 1000+500 (Adding the previous 2 years) equaling 1500/-. In the fifth year he invests 1500+1000 (adding fourth year plus third year) equaling 2500/-. In the sixth year he invests 2500+1500 (adding the investment of fifth year with the fourth year) equaling 4000/-. If he continues in this fashion by the eleventh year i.e at age 52 he would have amassed a larger corpus than Anil at age 60.
So what’s the catch here. The catch is that you have to maintain the disciple of ensuring you are investing the sum of the previous two years. As an example in the eleventh year of the above situation with Tom, he would have to invest 44500/- and over the years he would have a total sum of 116000/-
I have not included the maths of how I have made the calculations, but if you are interested, I could share them with you separately.
Now knowing human nature its very difficult for human beings to ensure discipline of increasing the investments to be the sum of the previous 2 years ( Read Charles Duhigg “The Power of Habit” or Marshal Goldsmith “Triggers”). Second the physical ability to earn so much money that you can spare a summation of the previous two years is quite difficult except if you are an entrepreneur in a high growth market with a high growth product or service (what Richard Koch calls the STAR principle).
For most mortals its better to start early and put investments in automatic route in a Systematic Investment Plan so that the money gets puled out of your account before you get to use it. Its easy and because you don’t have to think, it gets done. But if you have crossed the age of 35, you don’t need to lose heart. As long as you can continuously increase your annual investment at a significant rate you could still meet your long term plans and retire rich.
Till the next time.