There’s no magic in compounding
Question: Can you explain what this magic in compounding of returns means? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram and Facebook.
Answer: Personal finance is such a cerebral exercise that can easily turn off the most enthusiastic of savers and would-be investors. Consider this definition of summer solstice by Pagasa (Philippine Atmospheric, Geophysical and Astronomical Services Administration): “Philippine nights are at their shortest and daytimes are at their longest during the summer solstice, which falls on June 21 at 11:32 a.m. (Philippine Standard Time). This is the time when the sun attains its greatest declination of +23.5 degrees and passes directly overhead at noon for all observers at 23.5 degrees north latitude, which is known as the Tropic of Cancer. This event marks the start of the apparent southward movement of the sun in the ecliptic.”
There is a high degree of probability that only the first sentence will be retained by the reader.
Math, which is greatly relied on in personal finance, is looked at in the same way. In fact, we at the Personal Finance Advisers of the Philippines joke that when there was a move to take out Pilipino in the college curriculum, there was a clamor to take out math instead.
Financial planners have devised ways to “ease the pain” of having to use math through the practice of framing, which others call paradigm shifting. One way is to frame math with something fun and mystical, hence the creation of the term “the magic of compounding.” And where else is the magic of compounding more evident than in the Rule of 72.
Under the Rule of 72, your investment will double in “x” number of years if you divide 72 by the absolute value of the return that your investment is giving. On the other hand, if you divide 72 by the number of years that your investment is claimed to double, you will arrive at the implicit net annual compounded return on your investment. But please note that the doubling is just math. There is nothing magical about it. Plus, the doubling refers to a single investment, and that the return and time at which the investment doubles are never guaranteed.
The brain suffers from number numbness because it finds difficulty in grasping such a complex concept in numbers. But again, it is just math, which spits out predictable results given certain inputs.
Here is another example of how mechanically math works. We will “guess” your birth month and birth date. Using a simple calculator, do the following:
Enter the number seven
Multiply by the month of your birth and press the equals sign
Subtract one and press the equals sign
Multiply by 13 and press the equals sign
Add the day of your birth and press the equals sign
Add three and press the equals sign
Multiply by 11 and press the equals sign
Subtract the month of your birth and press the equals sign
Subtract the day of your birth and press the equals sign
Divide by 10 and press the equals sign
Add 11 and press the equals sign
Divide by 100 and press the equals sign
Did we arrive at your birth month and date? There was no magic about it. It is just math mechanically operating.
But if it is through this “magical” framing mechanism, in particular the compounding of returns, that you can persuade yourself to invest, then by all means use it and let others use it on you. INQ
Efren Ll. Cruz is a registered financial planner of RFP Philippines, seasoned investment adviser, bestselling author of personal finance books in the Philippines. Become a Yaman coach. For details, email [email protected]. To learn more about personal financial planning, attend the 91st RFP Program this July 2021. To inquire, email [email protected] or text at 0917-6248110)
