Tap into the amazing power of compounding

 

Forget about location, location, location being the key to a good investment outcome. For now, let’s think of the most important ingredient as being regular, regular, regular!

A regular savings plan can turn small amounts of money into a sum that can take you closer to your dreams much faster. All that’s needed is time and discipline.

When you invest over a period of time, compound interest is your best friend. In effect, it means you are earning interest not just on your own capital, but also on the interest you’ve already earned. Over the long term, this might be phrased as “interest on interest on interest on interest on interest …” or more simply, “free money”! So how do you get this free money? This is how…

I = P(1+r)n-P

Don’t worry, we’ll do the maths for you, but this little formula contains a power that Albert Einstein is attributed to labelling “the most powerful force in the universe”. It calculates your net profit when you earn interest on the interest. That’s what compounding is all about.

A simple start

For example, let’s see what happens to an investment starting with just $100 and adding $100 each week from your regular income. Table 1 shows what the investment value would reach after five years and up to thirty years. In this example, we have assumed that the investment pays a return of 5% per annum (paid quarterly).

  5 years 10 years 15 years 20 years 25 years 30 years
5% return $29,598 $67,454 $116,037 $178,386 $258,402 $361,092

Table 1: Regular savings plan of $100 per week compounding monthly.

The results show that a regular savings habit can turn small sacrifices into real outcomes.

To budget or not to budget


Think about what you might have to do in order to save $100 per week to add to your investment. Maybe instead of eating out every week, make it a special monthly event. Taking lunch to work is a big saver – or you could cut back on your coffee purchases if you’re a regular at the local café. Review essentials such as your mobile phone plan and utilities to get better deals and direct that extra cash straight to your investment.

It might sound picky, but in return for this self-restraint you can see what can be achieved:

  • the $29,000 in 5 years might go towards a deposit on your first home or an overseas holiday;
  • the $67,000 in 10 years might contribute to your young children’s secondary or tertiary education; or
  • the extra $258,000 in 25 years might help you to retire more comfortably or earlier than you thought you could.

Any of these goals would seem to make your small sacrifices extremely worthwhile in the long run. And remember to write down your financial goals as early as you can because it’s much easier to make those sacrifices if you know what they are helping you to achieve.

Reducing expenses is not the only way to find a spare $100 each week. Another good time to start a savings plan is when you receive an increase in your disposable income from a new job or a pay rise. Before you spend the extra money, put it away.

The trick is to start soon

Everyone’s ability to save is different. If you can’t save $100 every week, the above figures are still worthy of your attention. For example, if you can save $50 per week simply halve the results in Table 1. Conversely, if your savings capacity is higher, multiply the figures.

The results also demonstrate the effect of time and compounding returns on the value of your investment. The sooner you start, the less you need to save in order to achieve the same outcomes.

The difference 10 years can make!

Christine plans to retire in 20 years from now so she starts saving an extra $100 per week for this goal. Based on our simple calculations she might expect to have an investment of around $178,000 to add to any other superannuation or retirement benefits she has at that time.

Christine’s twin Ben also plans to put down the tools in 20 years, but he is confident that he can save more money than his sister. So Ben ignores any type of retirement planning for the next 10 years. He then saves twice as much as Christine – $200 per week – for the last 10 years of his working life.

Assuming a 5% return on the investment, the difference is staggering. By starting 10 years earlier, Christine will have saved just over $178,000 compared to Ben’s outcome of $134,743.

Even though his regular savings amount totals exactly the same as his sister ($104,000 over the period of the investment), Christine has benefited from the compounding investment returns on her money over a longer period of time, earning an extra $44,000 in interest – or better known as “free money”!

Another way to look at it is that Ben would need to save $265 per week for the last 10 years of his working life (a total of $137,800) to end up with the same outcome as Christine.

A couple of drags

But don’t forget to take into account tax and inflation. They act as drags on investment performance.

Let’s assume investment earnings remain at 10% pa and are fully taxable. What will your $100 grow to over 30 years at different tax rates?

 

0% Tax

(Allocated Pension)

15% Tax

(Super Fund)

34.5% Tax

(Average Taxpayer)

47% Tax

(Top Tax Rate)

$1,983.74 $1,269.25 $709.69 $488.66

Note: Includes 2% Medicare Levy.

As for inflation, although we are currently experiencing very low inflation, nobody knows how long this will last. If it reaches the Reserve Bank’s target of 3%pa, you will need $2.43 in 30 years’ time to buy something that costs $1.00 today.

There are many ways of minimising the effects of tax and inflation. Picking the right tax environment is clearly important. Capital gains are only taxed when an investment is sold, so growth assets have an advantage over those that only produce income. They also cope better with inflation.

Investment risk

Always remember, seeking higher returns generally involves taking higher risks but some of those risks can be managed with an effective and professionally constructed investment strategy.

But why do investors often miss out?

But what can cause investors to miss out on the power of compound interest if its so obvious? There are several reasons:

First investors may be too conservative in their investment strategy, opting for lower returning defensive assets like cash or bank deposits. This may avoid short term volatility but won’t build wealth over the long term.

Second, they leave it too late to start investing or don’t contribute much initially. This makes it difficult to catch up in later life & leaves them more at the whim of financial market swings. Fortunately, the superannuation system forces Australian’s to start early in life, albeit last year’s pandemic related early withdrawals may have thrown this off for some.

Third, they attempt to “beat” the market by either trying to time market moves up or down or buying and selling particular stocks. Getting this right is easier said that done and investors often end up getting it wrong – buying at the top and selling at the bottom which destroys wealth.

Fourth, they are not diversified enough.

Finally, some are sucked in over the years into investment opportunities seeming to promise a free lunch, which then fail. The key is to check the asset is producing fundamental value and not just dependent on the crowd pushing it higher.

Implications for investors

There are several implications for investors looking to take advantage of the power of compound interest.

First, if you can take a long-term approach, focus on growth assets like shares and property with a long-term track record.

Second, start contributing to your investment portfolio as much as you can as early as possible.

Third, find a way to manage cyclical swings. For example, invest a bit of time in understanding that the investment cycle is a normal part of investment markets and partly explains why growth assets have a higher return in the first place.

Finally, if an investment sounds too good to be true – implying a free lunch – or you can’t understand it, then stay away.

If you want to take advantage of “the most powerful force in the universe”, talk to us.

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