Compound Interest Basics

The Idea of Compounding

Compound interest is something consumers hate. With compound interest, not only are you charged interest on the principle, which is the money you borrow, but you are charged interest on the interest. The interest compounds on itself, making you pay more and it is something most people could do without.

Compound interest has actually been with humanity for quite awhile, dating back 2,000 years to the days of the Roman Empire. Back then, compound interest was regarded as the worst type of usury and it was condemned under Roman law. As well, the Qur’an and the Bible both contain references to compound interest. In the Qur’an it says “O ye who believe. Devour not usury, double and quadrupling. Observe your duty to Allah, that ye may be successful.” In the Bible, there is a reference to it in Leviticus 25:36-37 which reads “Take no usury or interest from him; but fear your god, that your brother may live with you. You shall not lend him your money for usury, nor lend him your food at a profit.”

In 1613, Richard Witt wrote Arithmetical Questions, which is considered a landmark book on compound interested. Completely devoted to the subject of compound interest, it was in sharp contrast to other books because most devoted only a chapter to the concept.

Enough about the history of compound interest though, how does it work? Well, if you take out a loan that has interest compounded on a monthly basis then it will work like this:

The loan is for $1,000 and you have one percent interest per month, which means that at the end month one you owe $1,010, and at the end of the second month you owe $1,111 and so on. So, the interest from month two is being added to the principle you owe, plus the interest you owe from month one. Naturally, this can quickly get out of control, especially when you are dealing with very high interest rates.

Most people prefer to see interest as a yearly percentage and for this reason many governments force banks and other financial institutions to disclose the equivalent total interest for the year. So, for one percent interest per month, the annual percentage rate would be 12.68 percent. This prevents people from being misled into thinking they are only paying one percent interest on their principle.

Compound interest should not be confused with simple interest, which is interest that is not compounded on top of it. Sadly, simple interest is not used very often. Compound interest is used quite a bit in finance and economics and if you have a credit card, you are paying with compound interest.

It is important to look at the laws dealing with usury to ensure that you are not becoming a victim of it through compounding interest. You want to ensure that when you get a loan, you are not going to be paying interest on interest to a degree that could cause you to default on the loan itself.

How Compound Interest Works

Making Money with Compound Interest

First Published: June 17, 2010 ADawnJournal.com

Compound Interest 101

When most people think about compound interest, they think about credit cards and how they lose money with compound interest. Most people hate compound interest, and they want nothing to do with it but what about if we told you that you can make money with compound interest? What about if we told you that there is the possibility to make money with something that you only think about as a bad thing?

Well, you can if you know how to use compound interest properly.

The first thing you need to do to make money with compounding interest is to start saving at a very early stage. Many experts will tell you that it is not how much money you begin to save with, but how early you begin to save. If you start saving at the age of 20, $2,000 a year, you will save $20,000 by the time you hit 30. That is much better than throwing down $20,000 at 30 and it is easier to handle on your pocket book as well. You also make more money on the money you save earlier. That $20,000 from the age of 20 to 30 will grow because of compound interest, while that $20,000 at 30 will not. The best way to look at this is with an RRSP. So let’s do some examples to show how compounding interest can work.

If someone is the age of 20 and they put in $5,000 into their RRSP, by the time the person is 65 that amount of money will have grown to $160,000 if it grows at eight percent per year. That may seem like a lot of money but it is not when you are trying to retire. Compounding interest works here because each year, the interest is put on top of the total amount in the account. Here is how:

• Age 20: $5,000 x .8 percent $5,400

• Age 21: $5,400 x .8 percent $5,832

As you can see, the interest has gone on top of the previous amount made from interest in the past year.

How do you make the compounding interest work for you then? By putting away money every single year, without fail. So, if a 20 year old puts away $5,000 every year, then by the time they retire they will have saved a staggering $1,932,528.09. That is enough to retire on! Here is how it happens:

• Age 20: $5,000 x .8 percent $5,400

• Age 21: $10,400 x .8 percent $11,232

• Age 22: $16,232 x .8 percent $17,530.56

That is how easy it is to build your investment over time using compound interest when you put money into your RRSP each year. When you do invest this way using compound interest, you need to remember three things:

• Begin the process early because the more you contribute early, the more money you can make on compound interest.

• Keep your investments regular and do not allow gaps in when you invest each year.

• Give it time to build. Do not be impatient because it is a slow process that can keep making you money if you give it the time.

How To Invest In China Through ETFs

Investing In China through ETFs

First Published: June 20, 2010 ADawnJournal.com

ETFs, or exchange-traded funds, are considered to be some of the safest forms of investment in the world today. If you are thinking of investing, and don’t mind less reward for less risk, then an ETF is what you should be looking at. Currently, China is a growing giant that will probably overtake the United States midway through the 21st century as the world’s largest economy and that has a lot of investors thinking about getting in on the action. However, China is still a difficult investment because of the chaotic market in the country; so many investors decide to invest in China through ETFs. If this is something that would interest you, then here is how you go about it:

1.   Look at various Chinese ETFs available based on their industry weights, how many holdings are in each ETF, and the expense ratios of the ETFs. Some that you can look at include iShares FTSE/Xinhua China Index, which is based off an index that has 25 companies in it. There is also the SDPR S&P China ETF and this one has more companies than the iShares ETF.

2.   You should consider not only investing in ETFs that are focused in China, but throughout much of Asia, which is currently booming while the rest of the world is suffering through a recession. One example ETF that you can look at is Vanguard’s Pacific ETF. Another one to consider is iShares MSCI Taiwan Index Fund. An index fund is a form of the ETF which is often considered the safest type of stock investment in the world. Another ETF to consider is the iShares MSCI Hong Kong Index Fund.

3.   In Canada, financial institutions like BMO, BlackRock, Claymore offer China and emerging market ETFs. Some of the examples are BMO China Equity, iShares China Index Fund, Claymore Brick ETF etc. A good resourceful ETF site is TMX Money. 

4.   After you have done the research for your ETFs, all you need to do is talk to your investment broker about what you want to invest in, and they will take care of it for you. However, this will cost you commissions and fees so if you want to keep from losing that money, you can invest yourself. The best way to do this is to get the ticker symbols of the ETFs that you want to buy into, go into your investment account and purchase these stocks as you would any other stock.

China is a booming country that is going places in the world. It will soon be the largest economy in the world, and with the world’s largest population it is also a force on the production and manufacturing platforms. That all being said, many feel that China is still a risky investment, and you should decide to invest in China based on your own risk tolerance and unique investment objectives. However, ETFs may provide a better alternative than directly buying stocks and also, it’s  a lot easier to get in on the action as China continues to take the world by storm and generate capital for the investors who can tolerate risk and put money into this growing giant from the Far East.

With some risks, ETFs can be still better but profitable, and may be the best option when investing in China.

What Is Time Value of Money?

Understanding Time Value of Money

First Published: ADawnJournal.com June 23, 2010

Everyone wants to know how much their money is going to be worth down the road. Not only that, knowing how much money you may have will help you save better and make more money. Over the course of this article, I will cover four important concepts. They are:

1.   Time Value

2.   Present Value

3.   Net Present Value

4.   Future Value

All of these concepts will center on the value of money. We all know that money is valuable, but what about the time value of it? What is it worth now, how much is it truly worth now, what is its future value? All of these need to be understood if you are going to get the most out of your money.

Time Value

The time value of money is the value that is given to the amount of interest earned by the money over a certain period of time. That means that if the money earns a few dollars interest, then its time value will be based on how much value will be associated with the money and the interest. Here is a simple example to help show what we mean:

Let’s say you have 100 dollars right now and you put it away in an investment that earns you 10 percent over the next year. That means that your original 100 dollars is going to be worth 110 dollars in about a year. So, 100 dollars paid out now, or the 110 dollars paid out in one year will have the same value to the recipient who assumes the interest. However, using the time value of money, we know that the future value of the money is going to be 110 dollars. What makes this important is it allows a person to determine their future annual incomes. That way, annual incomes are discounted and added together to create a lump-sum that is the present value of a total income stream.

Present Value

The present value of money is the value of money on a given date for a future payment, discounted to reflect the time value of money and other factors. In economics, present value calculations are widely used, as well as in business.

If you are given the choice between getting $100 now, or $100 in one year, you will probably take the $100 now because that gives you money immediately. This is where Time Preference comes in. For example, if the $100 is worth $70 in one year, then the present value of the $100 one year in the future is $70. When you have money you have two options, you can save it or spend it. The benefit from saving money is that later on it will incur interest and that will give you more money down the road.

When money is evaluated for its present value in the future, it is called capitalization. So, let’s look at an example.

If you have the choice between $100 today and $100 in one year, you will probably choose the money now but if the money in a year earns 10 percent interest, then you can have $110 in one year, more than you would get now. The present value of the money at the future date is going to be $110.

Net Present Value

The net present value of a time series of money, both incoming and outgoing, is defined by the present values of the individual cash flows. Net Present Value is a central tool in discounted cash-flow and is used when determining the time value of money for long-term projects, such as budgeting within a company. By measuring the excess or shortfall of cash flows, in present terms, it is possible for companies to make good financial decisions.

Companies will use Net Present Value to determine if an investment or project is going to add value to the company. By using the calculations for Net Present Value, it is possible to determine the NPV and therefore, the value for the company as follows:

·   If the NPV is greater than zero, the investment would add money to the company and therefore the project should be accepted.

·   If the NPV is less than zero, then the investment will take value away from the firm and the project should be rejected.

·   If the NPV is equal to zero, then the investment will neither take money nor give money to the company. This means that decisions to accept or reject the project, should be based on other factors.

Future Value

The future value of money is how much a given sum of money will be worth at a specific time given the interest rate and the rate of return. The value does not include things like corrections for inflation.

Here is a brief example to illustrate future value of money. If you are given $100 today, it is worth $100, however in five years it will not be worth $100 because of the changing value of money. You can put the money into the bank and it will either grow or fall in value depending on interest. In addition, if you buy something today for $100, you may not be able to buy that same item for $100 because of inflation increasing the purchase price. Inflation can grow by about half a percent to one percent per year, and that will mean that the item will cost as much as five dollars more in five years.  As a result, economists will evaluate the true value of the money over a given period of time based on future value calculations. Companies and economists will look at the real interest rate to determine the purchasing power change over a period of time.

What Is An ETF (Exchange Traded Funds)?

Exchange-Traded Funds (ETF)

First Published: ADawnJournal.com March 28, 2010

What Is An ETF?

An ETF is a type of investment product that trades on an exchange like a stock. However, unlike a stock an ETF is not made of a single entity. An ETF is made of a group of investments. These groups can be a group of stock, bonds, natural resources, commodities, precious metals, etc. In most cases, an ETF follows an Index, as an Index is already made of a group of stock (or other investment products).

Advantages of ETFs

Lower Cost – The ongoing cost of holding ETFs (called Management Expenses Ratio or MER) is lower than mutual funds or index funds. For example, An ETF MER can be in the range of 0.25% – 1.00%; a mutual fund or an index fund MER can run in the range of 1.00% – 3.50%.

Flexibility – ETFs offer more flexibility as they trade on the stock exchange and can be bought or sold throughout the day during regular trading hours. Mutual funds do not offer this option, as they can be transacted using the NAV (Net Asset Value) which comes out at the end of the day.

Diversification – As ETFs are made of a basket of varieties of investments, they provide broad diversification and convenience. It would be time consuming, a lot of hassle, and almost impossible to get the same level of diversification with anything else.

You See What You Get – A major advantage of holding ETFs is that at least you get the return of the underlying index the ETF is tracking. You know what you are getting and you see what you get. With mutual funds, it is totally different. In general, regular mutual funds are made of many individual stocks (or other types of investment products) and most of the time you will have a hard time seeing what you are getting.

Tax Advantage – Tax liabilities are created when trading occurs in the fund. Active fund managers are always buying and selling securities in regular mutual funds. When you sell your mutual funds, fund managers have to sell securities to provide you with cash for your sell. However, this is not the case when you sell your ETFs. When you sell your ETFs, trading can occur between other ETF units holders (in-kind trade) – triggering no capital gain. This means ETFs do not need frequent trading to pay an investor who wants to redeem his part. Less trading creates less tax liability and thus, minimal to none capital gains. However, ETFs do need to trade occasionally. This type of trading occurs when index changes (as they are tracking index).

Easier Asset Allocation – ETFs let you easily manage asset allocation as you are able to see your entire ETFs in one place (your trading account) and thus track and manage asset allocation easily.

Low Maintenance – ETFs allow you to hold a broad range of indexes with minimal supervision. Studies show that experienced ETF investors beat most professional fund managers with a fraction of time and effort spent.

Disadvantages of ETFs

Requires Investment Knowledge – Buying ETFs is not as easy as mutual funds. You need to have a trading account and need to be some sort of investment savvy to hold ETFs.

Brokerage Fees – Buying ETFs incur brokerage commission or trading fees – just like stock, you pay fees to buy and to see. This makes buying ETFs for smaller amounts not justifiable.

No Dollar-Cost-Averaging – Since ETFs incur fees each time and buy and sell, it’s not a good vehicle for dollar cost averaging.

Market Timing – Since ETFs are easy to trade, it may tempt investors to do market timing (buy and sell to chase returns) via frequent trading and thus incurring a lots of transaction fees. ETFs work best for long time investors.

How ETFs Choose Its Holdings or Products

ETFs mainly use two methods to pick its holdings. These are called: Market-capitalization /Cap-weighted indexing and fundamental indexing.

Market-capitalization /Cap-weighted indexing replicates a market as-is. In this methodology, bigger companies have greater influence. Most common indexes such as the S&P/TSX Composite and the S&P 500 use this method. In Canada iShares and in the U.S. Vanguard use this method to operate many equity ETFs.

Fundamental indexing picks stocks by looking at fundamentals (such as earnings, book value, sales, dividends etc), not by size. Fundamental indexing proponents argue that Market-capitalization /Cap-weighted indexing overvalues larger and undervalues smaller equities. So to get true value, stocks’ fundamentals, not sizes should be looked at.

There are other methodologies such as price-weighted indexing, equal- weighted indexing, etc. If you are looking for the best indexing, there is no clear answer. You need to do a little research to find the best one that suits your needs. If you are looking for the cheapest one, Market-capitalization /Cap-weighted ETFs are usually the winner.

How to Buy or Sell ETFs

Since ETFs trade on exchanges, you need a trading account (discount brokerage account) to buy ETFs; just the same way you would buy stocks. In Invest Now, I have mentioned how to open a trading account at an ease.

Are There Any ETFs In Canada?

Canada is the country that invented ETF. |The world’s first ETF traded on the Toronto Stock Exchange in March 1990. Here are some ETF providers in Canada:

iShares Canada – The oldest and largest ETF provider in Canada.

Horizons – Horizons offers AlphaPro and betaPro ETFs. Horizons AlphaPro is the only ETF family that is actively managed ETF in Canada. Horizons BetaPro offers leveraged and inverse leveraged ETFs to profit in both bull and bear markets.

Claymore ETFs – Claymore offers various innovative intelligent investment strategies ETFs. This is the only company that offers ETFs that can do DRIPs (dividend reinvestment plan) in Canada.

BMO Exchange Traded Funds – New player in the ETF markets and the only major Canadian financial group to offer ETFs.

TMXMoney has a section on Exchange Traded Funds and I strongly encourage you to visit it.

How to Build an ETF Portfolio

I recommend you read these two articles I wrote.

How to Build an Investment Portfolio

What Is Asset Allocation?

A Dawn Portfolio (I am still working on this project and will add a link once done)

Once you are finished reading, do some more research and do some more reading from various other sources to have a good grasp of ETF. And then, if you are confident enough, construct a suitable portfolio that fits your needs. If you are not comfortable figuring out on your own, seek help from professional financial advisors.

NB – Currently, I do not have any articles giving ETF ideas, examples of Indices ETFs track and so on. I will be writing more on these in the future.

How Risky Are ETFs?

No investments come without risk (except some fixed income products like money market instruments, T – Bills, etc). However, due to the fact that ETFs provide a broad diversification with a wide variety of investments, you may be able to reduce some risk.

Last Word

As I mentioned in Invest Now, investment is an art. As such, it requires discipline, hard work and consistency. Do not blindly follow any ETF model portfolios or tools just because it looks cool. You are different than anyone else – make an educated decision based on your time horizon, risk tolerance, financial goals, and your overall financial situation.