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Monday, September 28, 2009

Power of Compounding Gain

Recently when I discussed setting a financial goal with some friends, and one of them talking about reaching personal net worth more than six times from our current annual income in another four years. Well, at first I thought reaching that kind of personal net worth is quite impossible, but after doing some calculation I believe reaching personal net worth of six times our annual income is possible, at least reaching closer to that amount.

First, we must realize that it is not possible to save 100% of your annual income. We have expenses, loan and many more which will takes up huge percentage of the annual income, unless of course, we have very low amount of expenses and loan. Even then, we cannot deny that we are not going to save 100% of our annual income, else how are we going to survive in this world where everything needs money?

Back to the real issue, how I suddenly come to the conclusion that the financial goal is achievable, at least for me, but at one condition, which is I have to invest 20% of the annual income and reinvest the 20% profit that most likely I can get from my current investment. That is the compounding gain that I'm going to get (if everything goes according to the plan).

Let's have the example of a person A, earning 10K per year, reinvesting 20% of his profit and investing 20% of his annual income. If we assume that A never has increment through out his/her employment, so every year he will top up 2K to his investment capital and reinvest 20% gain for the previous year. It will takes him 10 years to get his/her portfolio to be six times the annual income. Let's look at the table below:-

Capital 20% of salary 20% profit End year capital Year
2,000.00 2,000.00 400.00 4,400.00 1
4,400.00 2,000.00 880.00 7,280.00 2
7,280.00 2,000.00 1,456.00 10,736.00 3
10,736.00 2,000.00 2,147.20 14,883.20 4
14,883.20 2,000.00 2,976.64 19,859.84 5
19,859.84 2,000.00 3,971.97 25,831.81 6
25,831.81 2,000.00 5,166.36 32,998.17 7
32,998.17 2,000.00 6,599.63 41,597.80 8
41,597.80 2,000.00 8,319.56 51,917.36 9
51,917.36 2,000.00 10,383.47 64,300.84 10

While the amount seems nothing, but if we look at the profit, it is increasing yearly. So, if A continue to invest diligently, eventually he/she can become millionaire in just 25 years down the road.

309,480.00 2,000.00 61,896.00 373,376.00 19
373,376.00 2,000.00 74,675.20 450,051.20 20
450,051.20 2,000.00 90,010.24 542,061.44 21
542,061.44 2,000.00 108,412.29 652,473.73 22
652,473.73 2,000.00 130,494.75 784,968.47 23
784,968.47 2,000.00 156,993.69 943,962.17 24
943,962.17 2,000.00 188,792.43 1,134,754.60 25

Imagine, if you are start to work at the age of 21 (no increment through out your employment), by the age of 46, you are a millionaire. So, for those earning low salary, fret not. If you can invest diligently and invest wise, eventually becoming a millionaire is no problem - you still have 9 years before retirement age (55).

The concept is simple, but how many of us will be able to achieve that by investing wisely? That will be another topic, which we can discuss.

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