RRSP Season

Take it from Einstein, it's all about compounding

Special to The Globe and Mail

This undated file photo shows famed physicist Albert Einstein. Scientists at the European Organization for Nuclear Research, or CERN, the world's largest physics lab, say they have clocked subatomic particles, called neutrinos, traveling faster than light, a feat that, if true, would break a fundamental pillar of science, the idea that nothing is supposed to move faster than light, at least according to Einstein's special theory of relativity. (AP)

Excerpted with permission from RRSPs: 41 Strategies Canadians Need to Know About Our Country’s Single Greatest Tax Planning Tool, by Preet Banerjee ©Preet Banerjee

Albert Einstein knew a thing or two about investing

If you are reading this book on RRSPs, then I think it would be safe to assume that you have an interest in retiring from the daily grind one day down the road (or helping others to do so). I think it might also be safe to assume that at some point in time, you’ve come across one of those examples of how saving $100/month for x number of years will get you $1-million. If you were like me, it piqued your interest and you started playing around with a calculator trying to figure out how much you would have with numbers that more closely reflected your own situation. And that’s how “it” starts for many. Your journey to be more involved in your personal finances is usually sparked by one story, example, article or book that you came across. In the interests of “paying it forward,” here follows an example that you can add to your arsenal, or perhaps share with someone who might then “get the bug” and start their own journey to greater financial security.

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The title of this section is “Albert Einstein Knew a Thing or Two About Investing” – I’ll explain below why I said this, but in the meantime, I want you to answer the following question as fast as you can based on your gut instinct:

You have been offered a job contract for exactly 30 days and 30 days only. You have to choose between two ways of being paid:

1) $100,000 a day

or,

2) You start at one penny for your first day, but every day your pay doubles. (i.e. your pay on day 2 is two pennies, and day 3 is four pennies, etc.)

Which pay structure would you choose? Make your decision right now.

If you were like me, you would have a feeling in the back of your mind that it probably would make more sense to choose the doubling pay since the power of compounding growth is explosive, given time. But then you would do the quick math and consider that $100,000 a day for 30 days is a cool $3,000,000! So, if you were like me, you would have chosen the $100,000 per day.

Let me give you some more information – and see if you would change your mind. I will tell you that for the “doubling pay” scenario:

On Day 10 you would have earned $5.12 for that day.

On Day 20, you would have earned $5,242.88 for that day.

Perhaps the $100,000 a day is starting to sound like it was indeed the right choice? Well if you did pick the $100,000 per day like I did – then I’m glad I wasn’t the only person who got it wrong! I’ll spare the explanation and just show you:

Day 1 $0.01

Day 2 $0.02

Day 3 $0.04

Day 4 $0.08

Day 5 $0.16

Day 6 $0.32

Day 7 $0.64

Day 8 $1.28

Day 9 $2.56

Day 10 $5.12

Day 11 $10.24

Day 12 $20.48

Day 13 $40.96

Day 14 $81.92

Day 15 $163.84

Day 16 $327.68

Day 17 $655.36

Day 18 $1,310.72

Day 19 $2,621.44

Day 20 $5,242.88

Day 21 $10,485.76

Day 22 $20,971.52

Day 23 $41,943.04

Day 24 $83,886.08

Day 25 $167,772.16

Day 26 $335,544.32

Day 27 $671,088.64

Day 28 $1,342,177.28

Day 29 $2,684,354.56

Day 30 $5,368,709.12

Okay, so without adding up the running total, you can just look at the last day and see that $5,368,709.12 for that one day is more than the $3,000,000 you would have earned with the $100,000-a- day scenario.

This is an example of the power of compounding growth. It is such a powerful concept that, as rumour has it, when Albert Einstein was asked (during the height of the interest generated by his work in physics and the special and general theories of relativity) if the concept of relativity was the most important concept man will ever discover, he answered “The most powerful concept in the universe is compound interest.”

And who am I to argue with Al?

The point of the story is that the explosive growth didn’t really happen (in absolute terms) until the end. The doubling pay structure looked pretty boring for a long period of time before things started to get really interesting. If you can wrap your brain around this concept, you are half way to understanding how anyone can create significant wealth with a little bit of discipline and a decent amount of time.

You will find that I don’t make investment recommendations in this book – but for my projections of asset growth I tend to stick closer to the 4- to-8-per-cent range for rates of return which is closer to the actual performance of many long-term investors. There are myriad sources of information on picking the right investments but I will tell you that the common themes as to the reason some people have managed to create real wealth as opposed to others is time and discipline.

Time: Because no-one can double their money every year, let alone every day.

Discipline: Because before you can become an investor, you must first become a saver.

There is no real secret to creating wealth if you want to do it prudently. Let me draw an analogy to one’s health: Everyone knows that if you want to be more fit, you basically have to have a proper diet and exercise properly. If you have the discipline to do these things, then given enough time, you will be physically more fit. A personal trainer’s effectiveness doesn’t rest so much within their unlocking of closely-held secrets about food and exercise – it is more often than not simply a function of making you do what you know you have to do.

So with respect to your finances, your diet should be information (the business section, the Internet, personal finance books, advisers, etc.) Your exercises are budgeting and saving, investing, tax planning, estate planning, mortgage planning, insurance planning, goal setting, etc.

The sooner you start saving – the sooner you start retiring. It’s (almost) as simple as that.

 

Excerpted with permission from : RRSPs: 41 Strategies Canadians Need to Know About Our Country’s Single Greatest Tax Planning Tool, by Preet Banerjee ©Preet Banerjee.

 

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