Tuesday, May 26, 2015

Day 52: The Economics of Friendship - A Theory

I believe investing in friendships and investing money are extremely similar. I want to take some time to explain why I believe this

My theory is that both rely on compounding interest to increase the original investment over time. So, this is going to be a primer in investing money, but it will all make sense in the last paragraph (I think there has to be a disclaimer here about how I'm not a professional and do not get paid for my advice). 

Investing money is quite simple. Conventional wisdom over the last several decades has stated that if one wants to have a sizable sum of money near retirement age, one should invest in an index fund. An index fund is a fund that mirrors a major market index. The clearest example of this is the S&P 500. This is an index of the 500 largest companies in America by market capitalization. Companies like Apple, Microsoft, IBM, and the like are in this index. Funds exist to mirror this index because it has been shown that the S&P 500 tends to outperform most of the mutual fund managers out there. In short, an index fund like an S&P Index Fund is as close to a sure thing as you can get these days.

The big question remaining is when do you invest your money in something like this? The answer is, "the sooner, the better." Why? Because of the beautiful existence of compounding interest. The best way to explain compounding interest is to consider a snowball rolling down a hill (this same illustration applies to debt, which I will talk about in a Monday is for Money post). The original snowball continues to get added to and get bigger as it rolls farther and farther down the hill. This is compounding interest. The original investment gains interest over time and then there is more interest applied to the original investment and the initial interest gained, but the key is how often does the interest compound. Depending on the situation, it can be monthly or annually or some other determined time. 

Compound interest applied to an initial investment early on in life allows you to not have to be concerned so much later about investing a ton of money with much less return. Here's an example.

At 25, an initial investment of $10,000 compounded annually at 8% until age 60 (35 years) gives you a return of $100,626. Now take the same parameters for someone at just 5 years older for 30 years and the return is $68,485. That's a $32,000 difference just because of time!!! In other words, it would take a much larger principle amount or many more deposits to try and catch up.

Now what does this have to do with friendship? 

In short, my theory is that compound interest applies to friendship in much the same way. I believe the friendships we invest in early on in life tend to have a longer, lasting impact on us than those we develop later in life. The reason is compound interest. The friends I made at 12 are still in my life today. We don't talk as much as we used to, but the initial investment made then has been compounded so many times, that when we do talk, there's a greater value and depth than the friendships I've developed in recent years. This is that whole idea of "we haven't talked in forever, but when we do it's like we've never stopped" that all of us are familiar with. Yet on the other side, in order to develop friendships like that now, at 32, the initial investment has to be much higher and I have to make many more deposits. It is a heck of a lot more challenging now, but it is possible. 

I'm outta time, but I think I'm on to something. What say you?

No comments:

Post a Comment