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tony robbins

Compound Interest and Wealth Creation

I have recently finished reading Tony Robbins’s book Money: Master The Game. I highly recommend it. He makes a passionate appeal for people to understand compound interest and its impact on one’s wealth creation strategy. So this week lets take a look at this concept.

Interest is a powerful thing. When you borrow money, you pay interest. When you lend money, you earn interest.Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple or compound interest. Simple interest is calculated only on the principal amount of a loan.

Interest compounds. Starting with the principal, after interest is calculated and paid, it is added to the original amount to make a new larger principal. Compound interest is calculated on the principal amount and also on the accumulated interest of previous periods, and can thus be regarded as “interest on interest.” This larger principal now garners slightly more interest, and so on … This compounding effect can make a big difference in the amount of interest payable on a loan if interest is calculated on a compound rather than simple basis.

In the words of Ben Franklin: “The money that money earns, earns money”

On the positive side, the magic of compounding can work to your advantage when it comes to your investments, and can be a potent factor in wealth creation. While simple and compound interest are basic financial concepts, becoming thoroughly familiar with them will help you make better decisions when taking out a loan or making investments, which may save you thousands of dollars over the long term.

Compound interest is a double-edged sword. It’s great if you’re saving money but it can be cruel if you’re borrowing money. You can collect interest due to compound interest or you can suffer from paying compound interest depending on whether you invest or borrow.

You want savings to compound as often as possible. It’s better if you compound quarterly rather than annually when you’re saving money. If you’re borrowing, just the opposite applies.

Time is on your side. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.

Time is not on your side. Be careful about credit cards and mortgages as they use compound interest against you. It is wiser to always pay slightly more than the minimum repayment required so that you constantly reduce the capital amount. This reduces the compound interest that you repay. Suppose your interest rate is 14 percent and you add just $5 per month to your payment. In 10 years, you would have saved $1,315 in repayments. My family used this method way back in 2001-2005. We borrowed several million dollars (by the way did I say it was Zim Dollars) to buy a commercial property. It was a 15 year mortgage. We decided to pay more than the required amount and within 5 years we had paid off the mortgage and saved ourselves millions of dollars worth in interest repayments. Obviously the bank was not happy and they charged us a penalty. But this was nothing compared to the savings.

Time is either on your side or against you. Compound interest supercharges your savings because you earn interest on the interest you earn as well as the money you deposit. The longer you leave your money, the more powerful the compound interest effect. The longer you leave your money, the more powerful the compound interest effect. So the earlier you start saving, the more you will make from compound interest (but only if you don’t withdraw the interest). The same applies to other investments such as shares, where you regularly reinvest dividends, or the company reinvests its profits.

Compound interest simply means to REINVEST your investment return into your total investment amount. Total investment amount is called PRINCIPAL in personal finance. Your principal grows exponentially with the compound interest, that is how the magic works and that’s why we like to say it is powerful.

Compound interest can be your friend or your enemy. When it applies to debt it’s a wealth eroder. The longer you leave a debt which charges interest, the bigger the debt becomes. Compound interest works against you through either mortgage debt or consumer debt. At one time we took a mortgage to finance a company we owned. The company paid the mortgage faithfully for a few years and later inconsistently during a tough time. When we had to bail the company out 5 years it had paid over $150 000 but the outstanding balance was still $293 000 out of a $300 000 -10 year mortgage. I was so disappointed. Compound interest had worked against me and in favour of the bank. When I took over I undertook to pay more than the required amount and consistently so as to reduce the effect of compound interest working against me.

Compound Interest is really interesting interest that you should show interest in. It can either build you or destroy you along the wealth creation journey.

Risk Reward Myth in Investing

I hope today I can help bust one of the myths that hold new investors and wealth creators in bondage.

Some time ago we wanted to re-capitalize one of our businesses and so we decided to mortgage our house to unlock funds. To my surprise the bank insisted that we use our residential home which was in our personal names as collateral. They refused other properties which were in company names. They know you will most unlikely allow your family home to be repossessed. They also insisted that we give them unlimited personal guarantees. They obviously wanted maximum assurance that we would pay back the funds borrowed. They were protecting their principal. They were protecting their down side or ensuring that risk is minimal.

When we did the maths we realized that when you take a mortgage you generally pay close to 80-100% in interests on the property if you have a 15-20 year fixed rate mortgage. They also charge lots of bank charges that increase their return. They consider the money lent to you as an asset because it generates them income. So banks lent you money on a high return with very minimal risk.

They do not seem to believe the commonly held “truth” that for one to get high rewards in investments one needs to take a high risk. We now take this position as an inviolable law of investing. We tout it all the time that the higher the reward the higher the risk.

However I have recently discovered that this is not what bankers and high networth investors do. In fact they pursue high rewards with minimal risks. They call it an assymmetrical risk reward which simply means they take the smallest risk possible for the largest return possible.

The concept of an assymetrical risk reward means that when you invest you ensure that your principal amount is protected so that if the market does not perform you do not lose the capital, but when the market performs you gain the maximum returns. So you have a minimal downside but a strong upside potential.

This is why Warren Buffet’s cardinal laws of investing are: 1. Never lose money. 2. See Rule 1. So he structures his investments in such a way to protect the principal and never lose money. Tony Robbins studied some significant billionaires and to a man/woman they all spoke about the absolute need not to lose money by exploiting structures that have assymetrical risk reward. And yet conventional wisdom has us take risks which are unprotected because of the myth of the higher the risk the higher the reward.

Surely this is another aspect of the information asymmetry that separates wealth creators and wealth losers. My buying into the commonly held belief of risk reward symmetry has caused me to lose money and destroy wealth in the past. Never again! I have just decided to learn from the money masters and model after them. I have just determined to study this more and am beginning to see some potential investment structures that provide maximum return with minimal risk.

I am wondering what would happen if we sought to invest in projects and investment vehicles that have low risk and high rewards. These may be difficult to locate but they do exist.

For example when banks give you a mortgage they also insist on an insurance cover over the loan. What kind of insurance can you set up when you take a risk? What protection system can you institute to reduce your exposure when you invest? What strategies are you going to put in place to protect your principal and increase the potential pay off of your investment?

In an entrepreneurial setting bootstrapping can reduce risk by minimizing your capital while increasing your potential reward. If you started your business by earning through consulting and using that to raise the funds – you can minimise risk. Starting a business with a huge cash injection whether as a loan or as own equity is risky business.

I trust that this posting will challenge your thinking so that you start thinking as bankers do and NOT as they say!

God bless.

Invest in Yourself for Wealth

Like we said yesterday part of wealth creation depends on information asymmetry or put differently maintaining a knowledge edge. It follows that we need to learn to work harder on ourselves rather than work harder on our jobs. The marketplace for jobs is changing rapidly and Universities are trailing behind in training people for current job requirements. So you will need to develop yourself. Invest in your growth. I have many friends who repackaged themselves as social media marketers or consultants with no formal education. Now they have changed their earning capacity. Some by simply blogging and studying on certain topics have created themselves into powerhouses in emerging industries. Invest in your personal development. Make full use of the untapped knowledge base on the internet.

 

Through investing in yourself you make yourself valuable. The more valuable you are to more people the more your earning capacity. The measure of your capacity to attract wealth depends on the value you can contribute to more people. The more people you can serve through value addition, the more your wealth creation capacity grows. At a recent funeral two weeks ago I met a young man who told me that he is an indigenous businessperson. I politely informed him that there is no such vocation, and requested that he be more specific. He later told me that he was once a teacher. Tired of paltry salaries but passionate about education, he then invested in himself so that he could add more value to more people. He started coaching people for examinations on one on one basis. As he did he experimented with different teaching techniques. He adopted those that worked and discarded those which did not. As his competences improved and his success rate soared he started a college. Now he runs a premier private college in one of the mid-sized cities of Zimbabwe. He made himself more valuable and according to his confession he now has a significant wealth portfolio. His investment in himself created value that he has served on others in exchange for their resources. He gets paid for the value that he brings to the marketplace while most of his former colleagues complain about poor salaries in the sector.

 

Warren Buffet, that Oracle from Omaha, is famed to have said that the greatest investment he has ever made was the investment in himself. Add value to yourself. Make yourself more valuable to more people. How are you going to add more value to the marketplace without investing in your own value?

 

Investing in yourself means you may need to re-tool, re-skill yourself. Reinvent yourself. Assess your current skills profile. If its not taking you were you want to go, then re-educate yourself. Many people are stuck in professions that were either made for them by parents, teachers etc, or professions which they made as teenagers but are no longer fulfilling.

 

If you truly develop skills that the marketplace is looking for, it will reward you financially. The current marketplace no longer rewards people on time but on contribution. What is your contribution? What value are you bringing? Are you willing to learn a new and useful skill and profession? Retool to a different level.

 

The late Jim Rohn used to say, “For things to change you have to change. For things to get better, you have to get better.” Tony Robbins says, “Retool or be the fool.” In some professions they have what they call continuous professional development in order to keep the knowledge and competence edge. You destroy the information assymetry and you erode your wealth creation capacity.

 

By investing in your self-development and through retooling, you increase your potential to add more value to the world. Therefore you will contribute more, earn more and increase your impact.

 

As an avid champion nurturer and learning enthusiast, I dare you: Go add value by investing in yourself so that you earn more, invest your earnings and therefore create financial freedom for yourself. Invest in your personal development.

 

See you at the Top!