Why should you invest?

What did Albert Einstein call the 8th wonder of the world?

Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

So, the whole goal of any investment is compound your wealth over time.

How does compound interest work?

Simple example: Let’s say you have put $5000 in an index fund and it is returning 15 percent every year then your money will double in five years. How?

Year 0 — $5000

Year 1 — $5750 ($5000 + $750 (This is the appreciation on your investment))

15 percent of 5000 is 750

Year 2 — $6612 ($5750 + $862) (For the next year your return starts on the total from previous year. This is exactly the compound Interest)

15 percent of 5750 is 862

Year 3 — $7604 ( $6612 + $992)

15 percent of 6612 is 992

Year 4 — $8744 ($1140 + $7604)

15 percent of 8744 is 1140

Year 5 — $10,000 ($1311 + $8744)

15 percent of 8744 is 1311

Year 10 — $20,000

Year 15 — $40,000

Year 20 — $80,000

Year 25 — $160,000

Year 30 — $320,000

Year 35- $640,000

Year 40 — $1,280,000

So, a $5000 dollar investment at 15 percent return over 40 years will result in over a $1M.

But what if you make an investment which returns ~7.5–8 percent every year?

Year 0 — $5000

Year 1 — $5375 ($5000 + $375)

Year 2 — $6211 ($5778 + $433)

Year 3 — $6676 ( $6211 + $466)

Year 4 — $7176 ($6676 + $500)

Year 5 — $7714 ($7176 + $538)

Year 10 — $10,305

Year 15 — $14,795

Year 20 — $21,239

Year 25 — $30,492

Year 30 — $43,775

Year 35- $62,884

Year 40 — $90,221

You can see how a difference rate between 7.5 percent and 15 percent can result in over 1 million dollars in difference over 40 years period of time. So, the compound interest is extremely powerful.

But, where do you get a consistent 15 percent return? Generally speaking, it’s considered very hard to return 15 percent YoY for any one company or an investment over long periods of time.

So, what options are available for individual investors?

1. Stocks — US being the leader of free world, has some of the iconic companies in the world and plethora of high performing individual stocks. According to Buffet/Munger vast majority of people are better off investing in Index funds like S&P 500 instead of picking individual stocks. They’re just saying that based on historical performance of Individual/institutional investors. Also, historically very few stocks have ever performed in multiple decades. With every decade there’s a new set of best performers. The benefits with index fund is it captures all of the best performers over time and gets rid of the lagging performers.

Refer to this article to understand more about index funds.

2. Bonds — I’ve mostly avoided bonds as I don’t understand them enough. In my understanding they’re mostly bought and sold by institutional investors. However, nothing wrong in learning about them and see if it makes sense.

3. Real Estate — Lot of wealth was built by several investors in real estate especially in a burgeoning metropolis. An inexpensive house which is a primary residence for a family is definitely a great investment as you’d convert your rent money to a tangible asset. However, there’s some problems with considering primary house as an investment. A house is an experience and trying to make it an investment can lead to dissatisfaction over time. Of course, it is up to the individual to think about their opportunity cost and buy the home that suits their needs. There are some numbers, ratios etc that are suggested by some Personal Finance experts. I believe it is up to the individual and their opportunity cost. Some people buy rental properties and rent them out and get the tenants to pay for mortgage. This has its benefits and downsides. Investors should carefully consider several factors before making such a decision. First of all, real estate investment is heavy. It requires a lot of time and Energy. It’s not for everyone. One needs to carefully evaluate the downsides before making a real estate investment.

4. Others — There are other asset classes like Gold, Silver, Crypto etc. The FOMO in crypto market is very real. I’d advise to be very careful with investing in crypto. Understanding how to hedge the downside is very important with respect to Crypto.

In the US we’ve S&P 500 index which has historically returned 10–15 percent YoY. Need proof?

Look at this article

This article refers to Berkshire Hathaway’s 2018 annual shareholder’s meeting where Buffett explains about compound interest with S&P 500.

Warren Buffett has such reputation because he was one of the only investors who could provide such returns from almost 1960s till today. That’s over a period of 60 years.

Individual investors should also think about maximizing their 401k and reduce the burden of taxes by long term investments. I’ll follow up with one more piece about these two topics.

P.S: I’m heavily inspired by Warren Buffett, Charlie Munger and Monish Pobrai. A lot of the above content is based on their talks/conversations.