Wealth Creation Demystified

Wealth Creation Demystified

The wealth creation is often a wrongly understood phenomenon. Our effort to earn more and /or spend less does create wealth and for sure is a dominant driver of wealth creation process in the short term. All of us as salaried employees, professionals, business persons are all well focused on this aspect of wealth creation. We all work hard to move up the value chain to enhance our income month after month, year after year. But very few of us recognize that the wealth creation process is two pronged and that it is the second leg of wealth creation process –Making your money (saving) work for you that is far more powerful in the long term than working for money that we all do. It is the second leg which creates High Net worth Individuals (HNWI) *. There are about 7.8 Million HNWIs on our planet – home to more than 6.6 billion humans. It is even quoted that Sir Albert Einstein perceived the power of compounding (making money work for you) as one of the most powerful phenomena in the universe. I shall use three instances from History to drive home this concept of the power of compounding.

This is a story from Persia or perhaps from India. The Vizier had introduced the King (Shah) to a new game (shantaranj).The game was played by moving pieces on a board comprising of 64 squares. Evidently the most important piece was the king and the next important piece was the Vizier. The objective of the game was to capture the enemy king. Hence the game was known as Shahmat (shah: king Mat: death). Apparently the Shah was so pleased that he asked the Vizier to name his reward. Shrewd that he was The Vizier replied that he was a very modest man and would desire a modest reward. Gesturing to the board he asked that he be given a grain of wheat on the first square, twice that on the second square, twice that on the third square till each square had its complement of wheat. The king protested that this was too small an award for introducing him to such a great game. The King offered instead jewels or dancing girls. But all that Vizier wanted was little piles of wheat grains on 64 squares.

We are all like the King devoid of perception of the power of compounding. The number of grains started small 1, 2 ,4, 8, 16, 32, 64, 128, 256, 512, 1024, 2048,  4096, 8192, 16384, 32768, 65536, 131072, 262144, 524288, 1048576, and so on but by the time you reached 64th square you had 18.5 quintillion grains and they would weigh 75 billion metric tons (about 150 years of current global wheat production.)

So goes the second story that the American Indians of Manhattan sold the island in 1626 to a group of Spanish immigrants for a sum of $ 24 in trinkets. The Indians have been a subject of ridicule for the last 383 years for selling the island so cheap. Just pause for a second and assume that the $24 had been invested at 8% from the date of sale. The Indians would be laughing all their way to the bank with wealth of $ 150 trillion, multiple times the current value of Manhattan property. Now assume that the Indians could invest the money only at 6% instead of 8%. Their current wealth would shrink to $118 billion instead of $150 trillion. That’s the effect small decline of 2% in compounding can have on the wealth over a period of 383 years. We need to internalize this very power of compounding**.

Let’s move to the third illustration. In 1820 Africa had per capita GDP (gross domestic product) of $400 to USA‘s $1000. Over the next 180 years the Industrial revolution fires and THE GDP of USA grows on an annual average of 1.7% while Africa becomes a laggard and registers an average annual growth rate of 0.7%. The per capita GDP of USA in 2000 reaches $25,000 and USA becomes an affluent society while Africa is mired in poverty at per capita GDP of $1200. That’s what a differential growth of 1% over a period of 180 years has created.

And finally, a demonstration of how the power of compounding can unravel wealth over the period of our productive earning life, say 30 years.

The following table depicts the terminal value of Rs. 1 lakh invested every year at different rates and for different periods.

 

% Return

10 years

20 years

30 years

6

13.18

36.79

79.06

10

15.94

57.28

164.49

15

20.30

102.44

434.75

20

25.96

186.69

1188.98

 

You will observe that

  1. Over 10 years a sum of Rs. 1 lakh invested every year grows to Rs. 13.18 lakhs if invested at 6%. Over the same period the terminal corpus will be higher by 1.5 times if invested at 15% and nearly 2 times if invested at 20%.We certainly expected that. Investing at higher rate of returns will certainly generate higher corpus.

  2. Let’s now enhance the investment horizon from 10 years to 15 years. Now the power of compounding just begins to unravel. The corpus would be Rs. 36.79 lakhs if invested at 6% and higher by 2.8 times if the savings are invested at 15% and 5.07 times if the savings are invested at 20% instead of 6%.

  3. We enhance the investment horizon still further to 30 years. Now the power of compounding is in full flow. The terminal corpus would be Rs. 79.06 lakhs if the savings are invested at 6%. The terminal corpus would be higher by 5.5 times if the savings are invested at 15% and by as much as 15.5 times if the savings were invested at 20%. Instead of 15%.

Hence:

  1. If you were saving a sum of Rs. 1 lakh each year in a provident fund account that yielded a return of 6%. You would retire 15 times richer if the contributions were invested at 20% instead of 6%. How nice.

  2. Assume that the saving rate in the society was uniform at 20%. A person earning Rs. 5 lakhs a year and a person earning Rs. 77 Lakhs a year would be equally wealthy in 30 years if the person with earning of Rs. 5 lakhs a year was investment savvy and invested his savings at 20% per anum while the person earning Rs. 77 lakhs a year devoted all his time to earning current income and ignores to optimize the return on his savings. Now pause for a moment…. Just think of the efforts we need to put in terms of knowledge, efforts and time to move up from an earning potential of Rs. 5 Lakhs per annum to Rs. 77 Lakhs per annum and ask yourself what is the effort you put in to move up from a return potential of 6% to 20%. You have the answer already.

 

So the moral of the story is:

  1. Start saving habit early. The wealth creation is a slow process and needs a long time to unravel and create wealth for your needs.

  2. Devote a time to ensure that your savings do not get locked up in low yielding instruments for a long time. A differential of even 1% over a long time can mean difference between affluence and abject poverty as we saw in Africa USA example.

  3. Understand the risks in each of the instruments you are invested in. Albert Einstein defined a concept called space-time. Space and time are interrelated .We cannot have space without time and vice versa. So too in the universe of finance you have a risk-time concept. You cannot talk about risk of the instrument without time dimension. As we shall see in the next presentation that the investment in equities are risky in the short term but the statistics reveal that the risks get mitigated as the investment horizon increases.

 

I now invite you to read the article “Risk in equity related investments diminishes as investment horizon increases”

 

– Vijay Hede –

 

*HNWI: An individual with wealth exceeding $ 1 million.(other than self occupied property).

** The compounded value is calculated using the formula :

A = P( 1 + i )n

 

Where

A : current value

P : Initial value

i : Interest rate per year

n : number of years

 

To know more about Wealth Creation please contact

1) Anish Albuquerque : 0832 – 2228612 / 13 or email at anisha@pyramidfinance.com