[Investing] Compounding - How Wealth and Debt Build Up

There was a time, quite recent actually, where I received a shock from a credit card bill (from a boat-brand bank) - I forgot to pay my credit card balance of $2,389.29 (yes, I have to be this precise). I was topped up with a Late Charge of $60 and an Interest Charge of $145.30, a total of $205.30, not forgetting calls from the company "reminding" me to pay the bill and that they cannot waive the interest charge because of my forgetfulness (this is the first time I forget to pay the credit card bill by the way). I quickly paid the bill, and then closed the account. Well, this account has nice perks, like earning up to 3.5% interest, if you meet some prerequisites, like spending a minimum amount, cashing in your salary, etc. But the interest charge is too much for me. I do not have much money inside that account (heh~).

Not including the Late Payment Fee (as if the interest is not enough), the interest is already at about 6% (145.30/2389.29). Or ~8.6% if I include the Late Charge. This is a 1 month late debt. If I translate it to a per annum value, if I may, it is a 72% interest. To the bank!

What would happen if I continue not paying?

How Debt Accumulates

So I will owe the bank $2,594.59 on the Month 1. If I do not pay I incur yet another $60 and 6%, which becomes $2,810.27 ($2,594.59 *1.06 + $60). This is $420.90, or ~18%,  increase from the original sum owed. What was ~8.6% becomes ~18% in 2 months.

If I continue it for 12 months (assuming I do not get a lawyer's letter from the bank after 3 months), I will have to pay a whopping $5,819.92, 144% increase from the original debt. See the picture below.

The effect of compounding is clearly shown here. Interest is applied on what was owed. And interest charges pile up (or compound) quickly. At 6% interest rate each month (the compounding period) it takes about 12 months to double the amount owed (this is the Rule of 72). 

So the lesson learn is: Do not owe the bank money.

But you might think - but it is not fair, The bank pays us next to nothing (about 0.024%) for the deposits we make and they charge us so much when we owe them money? Well this emphasize the need for investing the savings, to make your savings work harder, and the good news is that we can make use compounding to our advantage too!

How Wealth Accumulates

Now suppose the above example, you are the one receiving the 6% per compounding period. With $2,400 in an investment that gives 6% per month, you will get about $4,800 in 12 months! 

But how does one really make compounding work? Many books I have read do not explicitly say, but I can think of some:

Reinvesting Dividends

This approach consistently buys a share that pays good dividends, and the dividends are used to buy in more shares. By good dividends I mean at least 4%, which is the rate where most blue chip stocks in Singapore are paying.

For example, for an investment of $1,000 in a stock that costs $1/share (hence I would have 1000 shares) and pays 10% dividends, I will receive $100 every year as dividends, which I will use to buy an additional 100 shares. The following year, I will receive $110 which I will buy 110 shares. At the end of the second year, I would have 1210 shares. This means I will have $121 dividends in the third year, and so on.

This is the idea, but in practise it is not that easy to execute namely because:

1. The number of stocks that can be bought is likely to be constrained by the minimum lot size. In Singapore the minimum lot size is 100 shares. If the dividends paid out can buy 1 lot of shares, no problem. The problems lies when we cannot buy 1 lot of shares with the dividends we received - likely due to too little holdings or the dividend yield is too low. The work around could be topping up the difference to buy 1 lot of shares.
2. 1 year is actually a pretty long time frame, relatively speaking. Discipline is required to be consistent. Suppose we are unable to buy 1 lot of shares with the dividends and we opt to wait for the next dividends period (which may be the following year, or may not depending if the company could pay dividends), we might actually forget about this little agreement we made to ourselves. Add in uncertainty, and the dividend next year may not be enough to even supply the balance funds to buy 1 lot of shares, which means waiting another year?  

Reinvesting Capital Gains

This approach is similar to dividend counterpart, but this time the stocks are actually sold, at a profit, and the money is used to buy the same stock or the different stock of the similar yield. Not only this approach has the challenges mentioned in the dividends approach, we have to be an expert in picking stocks that are cheap and we know that it is going to appreciate in the stock price. Definitely a no-no.

Regular Savings Plan (RSP)

RSP are plans that lets you put in say $100 every month to buy a stock or a fund (a unit trusts, ETF, etc). It makes use of dollar-cost-averaging, which the dividends and capital gains approach make use of. You buy more when the price is low, and less when the price is high, but all the value is the same. Except that RSP are generally on autopilot because chances are the funds are managed by professionals. Of course we can set up our own funds (or portfolio) to invest in, we can adopt the Dividends Reinvesting (it is also called Drip Investing) approach to do it. But RSP works only if the time horizon is very long, I would say at least 3 years.

Compounding is a double-edge sword. But understanding it is much more beneficial because it will help us avoid debts and make better investment choices. I have already discussed how a debts can accumulate into a nightmare because of compounding. The contrary is also true, that compounding can help accelerate returns for our investments.

Compounding is dubbed the eighth wonder of the world.

The only outstanding task to do is the execution of the plan, which will be in my future post.

Stay tuned!

~ZF