Future Value – Power of Compounding

Welcome back. What I'm going to do now is I'm going to show you the real power of compounding, we did ten periods that is okay. Let me show you the real power of compounding. So the question you notice and please write it out, what are the future values of investing $1,000 at 5% versus 15% for 90 years? Why am I asking this question? There's an interesting background. Turns out, the data on US stock markets became really available, very reliable data, staring in about beginning of 1926. And my Alma mater, University of Chicago, was very deeply involved in creating one of the most used data sets.

So 90 years have passed, so the interesting question people always wonder about is what would have happened if I'd invested in a low risk, I told you I'll talk about risk and personal investing throughout this class. Suppose you are putting 1,000 bucks, your great grandparents or grandparents had put away for you, in a relatively low risk investment, like buying a common bond, which common bond is where they take a loan and we'll talk about this later in the class. On the other hand, suppose they had invested in stocks

and that to more risky companies. Turns out, this is kind of approximately what rate of return you could have made over the last 90 years in the US context. So that's why I'm throwing out these numbers. And when I throw these numbers out and you do it, it's pretty shocking what you get. So use Excel and I will stay with you and do it. What is the future value of $1,000 at 5%, or $1,000 at 15%? And after how many years? 90 years. So what I'm going to do is, instead of going back and forth with Excel, I'm going to use a pen to write out what you should write in a cell.

So pick the first cell, call it A1 and go up to the function area which like I showed you and write this. So here you go. So put equal sign in the function thing and then what did I tell you? Write Future Value. And let's do it at 5%. So do this with me with an Excel open. Then, write how much. The first is the rate of return and what is the rate of return. The first option we have is 0.05. Please remember you have to be very careful entering the rate of return. It should be 0.05. Not five. Not in percentage terms.

I know we write it in percentage terms, but what I'm saying is in reality, you want to write 0.05. How many periods? Well, I pick 90 because now it's 2015, about 90 years have passed, right, 90. Then, what was PMT? PMT remember is something that you're getting every year, but right now we are only getting what? Put in money today and figuring its future values. So the PMT will be 0, apologize for that, we come to PMT in a minute. And then, PV is how much? 1,000, you don't need to write signs, dollars or stuff like that. So no percentages, no signs of dollars and so on. And then, press Return.

I will write what you should get and I'm going to cheat a little bit. I've done it already, so I'll write out the number. It's $80, [BLANK AUDIO] 730. And I'm going to be paying full 37 cents. So if you put 1,000 bucks, somebody on your behalf put 1,000 bucks 90 years ago at a 5% interest rate, how much would you have? You should get about $80,730. This is a fair amount of money. Suppose instead you already invested in a less risky thing. Which number would have changed in this whole setup? Only one number, and that's the beauty of Excel. You go back and change that one number, and that one number is 0.05. You can change it.

But let's go up instead of going down. So now, I'm doing the second part of the question, which will be mind boggling for you. What is the future value? Instead of 5% a relatively low risk investment, not 0 risk. But as suppose to that we are investing in stocks of small companies or the smallest companies which tends to have a higher risk and higher expect in return. And these are by the way approximately ball park numbers in the US experience. So the only number you really need to change, but I'll write it out is the 0.05. I hope you're doing this with me, otherwise I'll get upset and somehow I'll know regardless of where you are.

So you do this only number that is changed is which one?

But now when you press enter you'll blow your mind because i'm going to write only the approximate number without decimals. It's 290, 272 and 325. It has 0.21 after that. But see what see what happens, it doesn't that kind of make you pause? If somebody had put $1,000 in that small portfolio of stocks, you could I mean, technically, this is just after the fact, but you could have $290 million in the bank. Look at my face, [LAUGH] I mean it's like, orders of magnitude. So the interest rate is only three times larger, but look at the amount of money. So what does this tell you? That future value and compounding are very powerful.

It'll work in reverse when you're doing present value, and we'll do that. But I want you to think about it, stare at it. And tell me what are the two things that are driving this number to be phenomenally high. The first thing, obviously, is the time value of money. It's just 15%. In fact, the 5% was pretty high already. But the other thing which is acting like interest and helping compounding is the number of. Here, if you have had how many years? Not 1, not 2, not 10 but 90. And this is the combination of the two, that creates huge amount of effects of compounding. Stare at this. It's just mind-boggling.

As I said, even Einstein said man, I don't know what's going on. See you soon.