The Mystery Of Compounding

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Diamonds are nothing more than chunks of coal that stuck to their jobs -Malcolm Forbes

Compounding is either negative or positive. If you borrow, it will be against you, because you do not only pay back what you owe, you still pay interest on the principal and interest. This explains Nigeria’s debt position until recently. What was taken originally is less than a tenth of what we have paid back, plus the outstanding.

Recently, I handled a similar scenario, involving a businessman who is involved in lending. One way or the other, he gave out about N200,000 to another businessman as a loan with a monthly interest of 20%. This was harsh but the desperate businessman was in a tight corner and went for the loan. After about three years, he still has to pay back the original, plus over N2.2 million as interest on it.

Compound interest could be either negative, when used wrongly, or positive when properly used.

Positive compounding accrues to you when you invest the principal and re-invest any interest that accrues to you from the principal as well. An example is the case of a man that saves N6,000 monthly. He offloads it into an investment that yields about 20% per annum, for 25 years. If you also re-invest whatever interest accrues to you annually, i.e you do not take out of the original amount and the additions, then you would get N34.4million at the end of 25 years. The original sum of N1.8million was saved all together. Through compounding, it has grown to N34.4 million.

Let me explain it in a layman’s language. For instance, you buy a female Alsatian dog for breeding purposes. This Alsatian dog can multiply to 200 dogs in no time. How? When she first delivered, she had two other female Alsatians. The three of them (mother and two other Alsatians) then give birth to about 12 other Alsatians, and 10 out of these 12 are also female. You now have 13 female Alsatians that reproduce and give birth to 52 Alsatians. These 65 Alsatians then give birth to 260 Alsatians, depending on how long you wait.

Building a huge portfolio through compounding
A young man who I will call Wale in 2002 had about N298,950 (transaction cost inclusive) for investment. He wants N736m at the end of 35 years. The following was the agreement.
To achieve the above in about 40 years, his expected return on the investment would not be less than 25% per annum.

In line with the above, in five years, the expected value of his portfolio would be about N920,000. If the portfolio performs in excess, it would be channelled towards acquiring commercially viable property that would yield rentals. Thereafter, any other excess would be used for fund management and the returns from this would be invested in treasury bills.

The following stocks were purchased on behalf of Wale in 2002: 5,000 units each of Nigerian Breweries Plc, Union Bank Plc, First Bank Plc, Unilever Plc and Cadbury Plc. The actual value of his portfolio as at 2005, was N1.3 million (dividends and bonuses given by these companies between 2002 and 2005 inclusive). This was far above his expectation of about N500,000 for the same three year period. Thanks to the power of compounding.

You remember the Nigerian Breweries Bonus of 2004? For every unit of Nigerian Breweries stock you had then, you were entitled to an extra unit, free of charge. For example, if you had 5,000 units, you would get an additional 5,000 units free. This boosted the portfolio to a very large extent.

Apart from that, whenever the value of the stock per unit appreciates, it affects the overall portfolio.

Let’s say when you bought the Cadbury stocks, you invested N100,000. When it appreciates by 25% it would be worth N125,000, when it appreciates by another 25%, it would not be worth N150,000, no! but N156,250, another 25% appreciation would increase the value from N156,250 to N199,253 and on and on. This excludes bonuses and dividends warrants.

If this trend is sustained over time, you can be rest assured that in no time, you will join the millionaires’ club.

Let me round off with this true life story. As an undergraduate, I had a friend who was a lecturer in my department. Though he enjoyed such facilities like vehicle loans, housing allowance and the like, he wouldn’t join his friends in the car show-off. One day, I confronted him with the question about why he had not bought a car like his friends, and he answered that he was investing, so that he could use the interest to buy his dream car - a Mercedes V-Boot! Before I left the institution, this original investment of about N700,000 had grown beyond N2 million. Of course, he became a proud owner of a V-Boot. What a way to join the millionaires’ club! The money is still yielding compound interest till today.

Stock To Watch
Universal Insurance
Access Bank
Consolidated Hallmark
NEM
LASACO
IEI
Skye Bank
Japaul
Globe-Re
•Nwagu David is a leading business coach, a professional stock market analyst and a motivational speaker. You can reach him on 08065470051 or e-mail: campus_companion@yahoo.co.uk.