Simple Mathematics Behind Investment Planning
Investors often find that investment planning and the investment world is filled with a myriad of unknown factors and terms that perhaps make little sense to someone who has not studied economics at university.
While we as investment professionals are conversant with terms such as Sharpe Ratios, Total Expense Ratios and Reduction in Yield, many clients find these investment concepts a mystery.
To clarify just a few of these, I am going to cover three simple mathematical concepts or relationships that every investor can apply to help them understand the relative simplicity of how one measures performance relative to outcomes and financial decisions.
Compound interest
Benjamin Franklin said the following regarding compound interest:
“Money makes money. And the money that money makes, makes money.” So, let’s first look at the ‘magic’ of compound interest and it’s really not as daunting as it seems. The formula for compound interest is below:
For those who have not been scared off by the formula and are still reading, compound interest is simply interest (R) on interest. The concept of compounding, used in investing, depreciation of assets and hire purchase calculations has factors that influence the outcome of the calculation. While the rate of interest is very important to the outcome of the calculation, the most important factor is the number of years the money is invested (N) or commonly known as the term. The longer the term, the more time the investment has time to accumulate compounded interest. Conversely, if one looks at compounded interest on debt, reducing the term of a loan makes a massive difference to the total repayments, all because of the compounding effect.
The Rule of 72
The Rule of 72 is a quick, useful formula used to estimate the number of years required to double the invested money at a given annual rate of return. One will not necessarily find this in any financial textbook, but it certainly can be used as a rule of thumb.
Here’s how it works:
If your investment return over one year is 9%, then the time it will take for your investment to double in value would equal (72 /9%): 8 years. Another example of the use of this rule is if one considers inflation to be 6%, it will mean that the time it would take for your money to half in value would be (72/6%): 12 years.
A simple, but powerful and useful tool!
Investment return vs cost of debt
In a changing interest rate environment, we are often asked whether it is better to invest or to settle debt.
The explanation is relatively simple. If your net after tax return on your investments is higher that your home loan interest rate, then remain invested. Should your home loan interest rate be higher than your net investment return, especially in a high-interest rate environment, settle your bond.
It is worth noting that, because property is an asset that increases in value, one can confidently apply the concept. But one would be hesitant to apply this to a hire purchase on a vehicle that reduces in value every year.
I trust you have benefited from these short tips and clarifications. If in doubt, please contact your Wealth Specialist or qualified Financial Advisor to talk you through these helpful tips.