What Is The Real Future Value Of Your Investments? [TFC 128]

People are saying compounding… everything, everywhere. You hear this, especially when people are trying to push you financial products or talking about broad financial ideas. Whether or not do they actually practice compounding to their investment ideas, to their policies, to their strategies, actually… Adopt(ing) compounding doesn’t matter anymore. It’s just a thing that people say. 

Today, we’re going to spend some time to have a better idea of compounding… at least I want to give you a more nuanced perspective of what compounding means.

Good morning, everyone! I welcome you to another day with The Financial Coconut. In our podcasts, we’ll be debunking financial myths, discovering best financial practices and discussing financial strategies that fit our unique life. You get it, ultimately empowering us to create a life we love while managing our finances well. 

My name is Reggie, and today we’ll be spending time to talk a little bit more about the compounding effect.

Okay… Compounding has been pretty used in recent, personal finance era. All the content out there, a lot of them are talking about compounding. So what is compounding? Essentially, compounding is an exponential formula. Wow… A more chim (profound) word to explain a chim word. Very well done. 

Anyway, there’s no simpler way to say exponential formula. If you don’t understand exponential formula, please go and just go do a Google search. To put it in a very simple and lay(man) idea, in personal finance, it’s the longer you play an exponential situation, the bigger the rate of change. That means, the change that happens in year one, year two, year three, year four, the change gets bigger and even bigger, and bigger, bigger, bigger, following the year. It’s not the same amount of change, but a bigger and bigger, bigger change which in other words, we call it an increasing rate of change. 

So yes, as you can tell, compounding is actually a very scientific and very mathematical idea that actually has a formula to it. I’m going to share with you this formula today, as we begin our discussion.

So CF, the compounding factor… CF is equals to: open bracket, one + periodic yield, close bracket, to the power of N. Are you still with me? Are you still with me? I’m going to reiterate here. CF is equals to: open bracket, one + periodic yield, close bracket, to the power of N. It’s an exponential equation and when we translate it into personal finance and investments, periodic yield really is your returns… your yearly returns, that is what people are measuring and N is the number of years. Which is why, a lot of people talk about investment returns from an annual basis. What’s your annual yield and how long are you invested?

The annual investment returns is part of periodic yield and then the number of years is N. So CF is equals to: one + periodic yield, whole thing to the power of N. This is the compounding factor. I will not go further. If you want to go further, just go and geek out. It’s very easy… easy in a sense, that… Very easy to find resources all over the internet.

This is compounding factor and how does it then affect us into the compounding effect? The effect is a situation where you take the compounding factor, you times the present value, and ultimately what comes up is the future value. That is the effect in itself. 

To put it simply, everybody… when they invest their money, they all want to know what is the future value. How is it going to come out after 10 years? What is the future value? So, very simple… Through this compounding factor, you can calculate. The future value of your total investments will be equals to: the compounding factor of this strategy times the present value that you have, which is your current capital.

For example, your current capital is $100,000. Your current capital is $100,000 and you’re going to invest for 10 years. Over this period of 10 years, your periodic yield is going to be 10%. You just put all these into the formula, what you’re going to get is your future value. Your predicted future value will be $259,000. That’s about what the whole thing is trying to tell you. 

When you see professionals or agents, they give you some complex spreadsheet and all that, actually… This is all they’re trying to measure. Given a current value that you have, given a yield that we can predict, given the number of years that you are going to invest, what is the future value that comes up? This is the whole formula behind the compounding effect. That’s it. 

It’s not as complicated as what a lot of people want to put it out to you. You don’t need to be afraid of it. I’ve used technical terms in the first few minutes, so that you can go and do a little bit more research if you want to. Compounding factor… it’s all over the Internet, very easy to understand.

But today, I want to spend a little bit more time to be a little bit more nuanced with this compounding effect because I feel it’s been romanticized and it’s been capitalized. I want us to recognize some things that are part of this compounding effect idea and how does it then affect our lives.

The very first thing I want all of us to recognize is everything compounds. Some are just easier to measure. Out there in the market, experts, gurus, the professionals, they are always trying to talk to you about compounding when it comes to investments. Because why? It’s easy to measure. The formula is there, it’s very easy to put a yield to it. It’s very easy to put a number of years to it, it’s very easy to put the present value. Everything is in dollars. 

It is very easy to measure but you need to recognize everything compounds. Your experiences compounds, your relationship compounds, your diet compounds, your practices compounds, everything compounds. Some are just slower than others. Some are just easier to measure. Why is this important? Because I feel like compounding has become a miracle pill out there today. “Everything just compounding, just focus on compounding. Then, DCA (Dollar-cost averaging), then we compound. Add on to it, even better”. 

I feel like it’s becoming a miracle pill and a lot of people are overly vested in this miracle pill of compounding through investments which then lead them to become very frugal with their lives or lead them to push frugality to a whole new level or lead a lot of people to de-prioritize different aspects of their life like relationship, like taking care of your personal grooming and all that.

I was one of these people that was stuck in this idea of, “oh yeah, yeah. Compounding… investments, make, make, make money. This is my miracle pill, I’m going to get out of all my problems because of it”. And so… Because it is so capitalized and so propagated out there, I feel as a platform, we need to put it out there… this view that everything compounds.

I’m not saying that compounding does not exist. I’m not saying that what people say out there are wrong. No, it’s right, it’s accurate. It’s scientifically accurate. The formula exists. It’s mathematically zhun (accurate). It’s zhun. 

What I’m trying to tell you here is that because everything compounds, you cannot simply de-prioritize one thing, thinking that in the future, 10 years later, you can come back and pick up the slack immediately. It does not work that way. It’s like how a lot of people think “okay, I just focus on making money. I don’t need to take care of my health. I don’t need to have a relationship. I don’t need to care about my hobbies” and all that. 

And then, they think like “oh yeah, 5 years later, 10 years later, I’m going to come out on the other end with all money and I can pick up all the slack immediately”. The reality is it does not work that way. Compounding exists and if you don’t build good relationships over time, you need to start at a much lower present value because you don’t do anything about it. 

Eventually, when you start to realize 5 years, 10 years later, “oh yeah, maybe I should have better relationship”. You think you can immediately come back? No, you cannot. You got to start from scratch again because you didn’t compound all the friendships and the relationships that you have gathered while you were in school, while you were in your early days of your career. You ended up putting all your energy on making money and investing. 

To me, this is problematic. You must recognize that everything compounds: your experiences, your relationships, how you take care of yourself, your hobbies, your interests, your skill sets… all these things they compound.

If you choose not to take care of it, then eventually when you want to kick start again, you start at a much lower present value. But that is also not to say everything should be your equal focus because that is unrealistic and not humane. Everybody has limited resources, limited time. You got to prioritize, you got to make your choices.

Why I went on this whole discussion about everything compounds because I want you to recognize this reality. Every time you decide that you’re going to pause something, you got to sacrifice or you’re going to slow down on something, recognize that you will not be able to immediately bounce back once this other thing called investments and money is sorted. It does not work that way.

Which brings me to point number two and that is: compounding has direction. It can be positive, it can also be negative. We’ll talk to you a little bit more after a word from our sponsor. 

Okay, so there are two big case in this. One is of course a simpler one, which is your investments. Let’s say your periodic yield is negative, subjected to all sorts of reasons, whether is it because you did not invest your money, it’s getting eroded by inflation or whether is it you losing money over a period of time but because you got loss aversion, you want to stay in that stock, stay in an investment, you don’t want to pull out and re-allocate. 

All these reasons will subject your periodic yield to negative. Every year you lose 10%. You think you just lose 10%, one year, two year, three year but it compounds also, negatively, the longer you go. Eventually, it becomes a bigger impact than what you previously thought it was. It’s not a linear growth, you need to understand.

This is the part that we talk a lot about. We talk a lot about this: how to invest, manage your money, manage your risks, all that jazz. If you want more, go to TFC Stock Geekout, we’re going to make that the investment podcast. Go check out the podcast and we’re going to spend more time to talk about all those things.

In other words, you need to recognize that if you keep losing over a period of time, the loss will be a lot bigger than you think it is which is why to me, success breeds success, failure breeds failure. It is not a situation where failure breeds success. I want to reiterate this because previously, someone was telling me about this.

Oh yes… success breeds success. If you make money, over time you keep making money, the exponential effect is much bigger. If you lose money, you keep losing money, over time the exponential effect becomes even bigger. So failure breeds failure, success breeds success. 

The other part is also the interesting part which is an extension of what we were saying in point number one: everything compounds. So everything also de-compounds, right? Okay, okay… Clarification… the word is discount. Discounting, that’s the technical term. Not de-compounds, you think decompose? 

Discounting effect… but we are not going there. That’s not important. What is important here is that because everything compounds and if you don’t care about some of these things like your health, like your relationship, like your work quality, like your skills, your productivity and all the things that people are pursuing out there, the big mix of things. As long as you don’t care about it and your periodic yield is negative because you don’t care about it, eventually you reach a point where your future value is much, much lower. 

Remember Math? Remember Science? Those were the things when you were in school, you’d be like “yeah, I know. I can understand you all. Yeah, yeah. Very interesting, oh yeah”. Maybe not very interesting but at least, you know enough to get your A, to get your exams. 

Ten years of not practicing any of those things, today, your cousin, your kid come and ask you “how to do this?”. You look at it, you’ll be like “wah…”. You look at it, it look at you, you don’t know each other. Because this is exactly, you know… Compounding or discounting at play. Over time, you stopped practicing it, you stopped using it, it will reach a present value much lower than you think it is. The decay is much stronger. 

There are many other examples like if you don’t use the language for a long period of time or you don’t take care of your body for a long period of time, you anyhow eat, don’t work out, blah, blah, blah, eventually you see it happen. 

I hope that you recognize compounding has direction. It can be positive and also can be negative. In this case, negative is what we call a discounting effect. 

Which brings me to point number three and that is… Most important point… point number three, the biggest power of compounding is N which is the number of years and also the present value, not your periodic yield. Like we have established in the early part of the podcast, compounding factor is equals to: one + periodic yield, the whole thing to the power of N. Future value is equal to compounding factor times present value. 

Even if you (have) lost, you lost… You lost the whole formula, it’s okay. You just need to know that there are three factors that determine the future value of your portfolio or anything you choose to compound with and that is present value and in investment terms is what we call capital. Number two is periodic yield and in personal finance investment terms, we call it annualised returns or the returns you get every year. And also, N which is the number of years that you let this investment grow, or you let this thing compound. 

This is the crux of compounding effect. Why a lot of people talk about compounding effect and trying to tell you “don’t need to focus too much on periodic value. Stay invested. Work on the end”, because the longer you invest, the bigger the end, right? And also, the bigger your starting capital, the bigger your present value so your future value ultimately comes out much bigger. Which is why the compounding effect, later to the end will be even bigger because your present value is much bigger. 

And so, why? Why don’t focus on increasing your annualised return, your periodic yield and focus on present value, which is the total capital that you have and focus on N, the number of years that you’re invested? The simple reason is N, which is the number of years you’re investing and present value are very, very predictable numbers. In other words, they have limited variance. 

That means, these numbers don’t move around at random. Some people would say,”oh, but what if at first I want to invest 10 years then after that, suddenly I feel like I need to invest 5 years only because I got something else”. This is not random. This is your choice. 

You decide that, “okay, my investment has been five years, I’m done with this. I take it out”. This is highly predictable. There is no variance. And present value… Come on, once you’re invested, how to shake it? You can reduce the capital, yes, but this is also highly predictable. It is not a random situation because you decided that “I want to take out some capital”. 

Get the idea? Which is why in the world of investments, a lot of people talk to you about present value and stay invested. The longer, the better, N… Because they are certain and less variable. I would say you can extend this to every other way that you view different aspects of life. Some are harder to measure, yes. But there’re certain things that are very predictable that you can control and there’re other things that are not as predictable and you cannot control which brings us to periodic yield. 

Periodic yield is a situation where it’s harder to control. It’s very high variance out there in different investment tools. Some are more variable, some are less variable. This is what investment people call risk. The higher the risk, the higher the variability of the outcome. 

In other words, in investment lingo, when someone says something is very risky, this investment is risky, it means the possibility of different outcomes is very, very wide and very possible. All sorts of things can happen to this thing, that’s why it’s risky. (This is) not some emotional idea of like, “oh yeah, this (is) very risky”, or you know, “oh, I can take risk”. It’s not an emotional discussion, it is a very technical discussion of probability and variance, standard deviation, those kind of stuff .

But, okay guys… We are not there, we’re not there to discuss these kind of things. I’ve done 2 episodes in the early days of the podcast: Episode 76 and Episode 77 on how to build your own portfolio. You should go and check that out, because that is where I spent a lot of effort trying to explain this big idea of why portfolios are built in a certain way, what are people actually saying when they say risk and all that stuff. 

Which is why the biggest power of compounding is N, the number of years you’re investing, and also the present value, which is your total capital size today. Not so much periodic yield, because that is highly variable.

Of course, there are a lot of strategies that people are doing out there: diversified portfolio, modern portfolio theory and all those things to try to make sure they can predictably produce a consistent yield which is why they want the periodic yield to be consistent then they can calculate. It becomes a clear strategy and not some rando strategy. You don’t know if it’s going to work out at the end. 

But that’s not the discussion for today. I want to keep everyone in check on this idea because I’m also hearing a lot of talks out there about “oh, you know, I want to make this much, this much, this much (money), in a short period of time. A lot of the listeners, especially some of the younger ones, they will spend a lot of effort trying to learn how to invest but actually, their present capital is damn small. 

It’s like $10k, $20k, $30k, it’s so small. Even if you are super, super… Okay, maybe if you’re super, super, super good… Yes, you will be able to make a flip then you call me, we can do a Financial Coconut product or something. 

But the idea is if you don’t have a big present value, it’s okay. Don’t be in a hurry to try to think “oh, I want to make $10k to a million dollars”. Realistically, what are the chances? Please do not take something that is improbable to be a hope. It will stay a hope. 

We are always talking about highly probabilistic stuff. We want to focus on what is possible. Focus on your present value, focus on N, especially in your early days of investing and try to keep periodic yield consistent. That’s the goal and that’s the beauty behind the compounding effect. 

With that, I’m going to sum up today the three points around compounding effect. It’s a very popular idea out there and I hope I give you a little bit more nuanced and clearer idea of this thing. Number one is everything compounds. Some are just easier to measure. That’s why everybody talk about investments, compounding but actually, your experiences, your productivity, your friendship, your relationship, they all compound over time.

Number two is compounding has direction. It can be positive or it can be negative. In other words, success breeds success, failure breeds failure. If you keep losing money over time, the effect is much bigger than you want to believe. The technical term for negative compounding is discounting effect. 

Which brings me to point number three and that is, the biggest power of compounding is N, the number of years invested and present value, your capital size to date, not the periodic yield or the annualised returns that you can make. Because that is a little bit harder, or in fact, a lot harder to predict consistently which is why there’s all this modern portfolio theory, broadly diversified and all that. People keep telling (you) all these, because they are trying to control the periodic yield. 

With that, I hope you learnt something useful today. See ya.

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With that, have a great day ahead. Stay tuned next week and always remember: personal finance can be chill, clear and sustainable for all.

Okay, so… I want to say, I know some people made some good money over these two years of run. Because of highly liquidity, because there are all these different products that perform very well. You have a very focused portfolio. You may have done a very good job, which is great. One year, two years… But what is your annualised return and your periodic yield over time? I think that’s where we are looking at things. 

Yes… If you have made a good run in your investments, it’s okay to put some into more predictable situations. Put some money into the predictable ones. It’s not always every day, Sunday… Every day you get good things.

But yes, I congratulate you if you do well. For every one of you that choose the very… more boring method because you subscribe to compounding, you subscribe to broadly diversified, I hope you get the idea after listening today. As to why it exists this way, why people are talking about it this way and find comfort in your decision and your strategy. Keep stress testing your investment thesis. Eventually, you will find something that work for you and help you achieve your goals. 

Which is what I’m going to talk about next week. I’m going to spend some time to talk about the first principles of personal finance. As we reboot the year, first two months of the year… I know a lot of people are thinking of all these different things.

I want to bring us back to the first principles of personal finance. At least the stuff that I’ve gathered over the few years of creating content in this space. So yes, take care and Happy CNY (Chinese New Year). 

I think this is going out during CNY, we shall see. If not, then… if I’m late to the game… We’ve got 初一 (first day of CNY) until 15th, right? So yes, still Happy CNY to all of you! Take care.