Imagine two friends called Andrew and Sarah who each suddenly receive a windfall of cash of UGX 100m. Andrew gets excited and buys a new car, the latest iPhone, moves to a better apartment, and before long only has UGX 50m left. He suddenly realizes he is running out of cash and quickly invests whatever is left in an investment account which generates 10% per annum.
Sarah, on the other hand, is rather cautious. She immediately invests her windfall in a unit trust and decides to eat only 10% of any interest she earns each year and reinvests the rest.
Our two friends have chosen different paths. Andrew has eaten some of his capital while Sarah has decided to only eat a portion of her fruits. We need to check on our friends in twenty years to see how these different paths lead to very different outcomes.
Andrew ends up with about UGX 336m while Sarah has about UGX 560m. The difference is explained by the principle of compounding and the effect of time. Andrew starts investing with a much smaller principal compared to Sarah and with the effect of time, the two amounts compound at different speeds. This is quite interesting given that in both cases, they both “eat” almost the same amounts. Andrew eats UGX 50m in one go, and Sarah eats about UGX 51m but spread out over twenty years.
This scenario demonstrates that it is important not to touch our principal as much as possible. It is better to lock away the lump sum in some safe place and only eat a portion of the interest. This piece of advice should be seriously considered by retirees and others who receive large lump-sum pensions or payments. The research shows that most of them lose this cash within two years. A better approach is to invest the cash somewhere safe and only withdraw a portion of the interest.
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