Published on August 25, 2022
Let’s understand how the ‘compounding’ effect can make you thousands!
The most powerful example of the impact of time is ‘compounding’. You’ve probably heard the term – you probably did an example in your maths class in around Year 8. However, there’s a good chance that since then you’ve forgotten its significance. Compounding interest is the principle of ‘re-investing’ the returns generated by your investments, which allows those returns to start generating their own earnings. This is where your money really starts working for you. Understanding and using the principles of compounding is the secret to really substantial investment growth.
It works like this. Imagine you make an investment of $1,000 which grows 10% in one year. That growth means you will have earned an extra $100 simply by having your money working for you. Now, if you leave that balance of $1,100 ($1,000 + $100 interest) untouched for the following year (rather than withdrawing and spending the $100), you’ll earn interest in that year on both the original $1,000 and on the extra $100. So in the second year (assuming the same rate of return) you’ll earn $110 in interest. Now you have $1,210 in your account, which in the next year again will earn $121 in interest. And so on. Every year, the amount of interest earned will be higher than in the year before.
The impact of compounding can be substantial. Leave that investment in place (again assuming a constant rate of return) for 25 years and the interest earned in a single year will be as much as the original investment.
Btw if you are interested in reading a great book on money and explaining compounding interest (apart from my own book The Money Sandwich), check out ‘The Richest Man in Babylon” by George S. Clason, written back in 1926 and its endless money tips and strategies are timeless.
Now let’s look at a practical example.
Assumes that Investor B opens an investment account at age 19. For 7 consecutive years they invest $2,000 (in total $14,000) which earns 10% pa after tax (average 10-year historical return for most Balanced Funds). Investor A makes no contributions until Investor B stops seven years later. They then contribute $2,000 every year until age 65 (for the next 40 years, a total of $80,000!), at the same theoretical rate of 10% pa.
Who do you think has more by the time they reach 65?
The answer is Investor B, who made only 7 contributions, compared to 40 contributions made at a later time. The difference is that Investor B has 7 more years of ‘compounding’ than Investor A. Those 7 years were worth more than all of Investor A’s 33 additional contributions.
So while this example shows the benefit of starting early, it is far more important to see the benefit of ‘time’ when it comes to allowing your money time to compound. As there is not much growth in the first few years but with a long term outlook, it shows how much your savings ramp up with interest in later years.
You could use a similar approach to save for any longer-term goal, whether that be travel, a major purchase or anything else.
This principle applies to any form of investment in which your returns are re-invested as they are earned. This can include savings accounts, term deposits (rolled over at the end of each term), managed funds, investment platforms and even individual shares with a dividend re-investment option.
The bottom line: whatever investments you make, do everything you can to re-invest your earnings. Put your money to work and let ‘compounding and time’ take care of the rest.