Page 65 - CalcBus_Flipbook

CH 8] Calculating Business 8-3

you receive, on average 5%. There can be quite a bit of volatility each year in the index.†
Contributing $300 to the fund with each paycheck and earning an average 5% interest
return, what is the fund worth to you, the old fashioned way, over your 50 year work life? Volatility: The
quick rise and fall of

Figure 8-1 indicates that after 10 years of disciplined setting aside, the fund is worth prices. In finance,
$53,220.96; your total contribution has only been $36,000 with an average compounded volatility is the degree
interest return of a modest 5%. When you reach the 30 year mark, your total contribution has of variation of a
trading price series
only been $108,000.00, this is only $300 per paycheck, your 10% tithe, and your fund has over time as
grown to $363,862.95. At the 50 year mark, the end of your work life, you will have contributed measured by the
only $180,000 and yet your fund is worth $1,565,949.44; the secret of compound interest and standard deviation of
time; capitalism at work for you. logarithmic returns.
Your savings and investments retirement fund is worth in excess of $1.5 million. Not bad Historic volatility
for a mere $300 per month contribution and a 5% interest return over time. But the caveat is measures a time
series of past market
that (1) you have to begin your tithe (10%) process now, (2) you must be diligent and faithful prices.
with it, (3) you must let time and compound interest work for you, and (4) if you are married,
your spouse must be equally diligent and faithful to the plan. No gambling, no vacations, no
purchasing a car from this fund as spending on this fund is ONLY FOR investments that
increase in value, such as stocks, bonds, real estate, etcetera. Those other things you save for
come out of the other 90% of your paycheck.
The above explanation is based on income not rising as you age, your not becoming more
experienced and worth more, or acquiring new marketable skills. Do monthly incomes increase
over time? Yes. Logically, holding to the 10% plan and the total value at the end of 50 years will
be greater than the example given here.
Given the numbers already generated (Figure 8-1), let’s review the retirement years after 50
years of work. For 50 years your purchasing power was $36,000 per year. Presume that you Accrued interest:
will live another 25 years after you retire. Your retirement fund has $1,565,949.44 in it; your is the interest that
annual take out over that 25 years could be ($1,565,949.44 ÷ 25 =) $62,637.98 per year. Not has accumulated
bad; a $26,638.00 annual pay raise in retirement. This is the beauty of Compounding Interest. since the principal
It DOES work when you have commitment and discipline to apply it. investment or since
the previous added
COMPOUND INTEREST savings payment if
there has been
In Chapter 7 you studied simple interest and all of the elements that go into its one already.
computations. Simple interest is calculated on a fixed principal for a period of time. The Interest is
interest is not added to your principal for a continued compounded computation. The equation calculated and
for simple interest is I = PRT. In contrast Compound interest is computed on the sum of an paid in set intervals
original principal plus the accrued interest. Interest earned is added to the principal and the (for instance
annually or semi-
computation is made again with the added interest to the principal. Compounding adds the annually).
interest to principal creating a new principal (principal + interest) and the rate of interest is
multiplied by this new principal amount to yield a higher interest than the previous calculation.
Compounded interest computations grows the principal over time, thus it does not remain
constant as in the simple interest computations. The principal will continue to increase as long
as the interest is allowed to accumulate and you do not make withdrawals from the fund.
Lending institutions, such as banks, savings & loans, and credit unions usually pay
compound interest on deposits in savings accounts to encourage their customers to allow the
funds to accumulate over a long period of time, and you will need to evaluate the interest you
receive on your deposited funds, determining if the interest return meets your long term
investing. Also these lending institutions commonly apply compound interest to the loans they
make; personal loans, credit card loans, mortgages to purchase real estate, auto loans or even
equipment loans. Lending institutions are not charitable institutions as they are in business
and expect to make a profit. The interest they charge is the cost to the borrower of they monies
they borrow and contribute to the profit the lending institution should earn.
8
Calculating Compound Interest

Compounding is a product of principal and earned interest added together and recalculating
interest on the summed amount, the compounded amount. Future value is the same as
compound amount. The difference between the compound amount and the original principal is
the compound interest.

† Note: that the average annualized total return for the S&P 500 index (stock market) since 1927 was 9.8%.
In 2017, the S&P 500's total return was over 19.7%.
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