Compound interest: the eighth wonder of the world

Compound interest: the eighth wonder of the world
29 January 2012

ASK anyone what the eighth wonder of the world is and they’re unlikely to say compound interest, but astute investors should sit up and take note.

Forget earning more money, forget the next ‘get rich quick’ scheme; understanding and exploiting the power of compound interest is your only realistic route to riches.

You may also think that you’re too young to start a pension or you may feel that dropping more money into your long-term savings account is a waste of time. There’s always next year or the year after that, right? Wrong! No matter what your age, now is the time to begin saving for retirement.

The amount of capital you start with is not nearly as important as getting started early. John F Kennedy famously said: “There are risks and costs to a program of action. But they are far less than the long-range risks and costs of comfortable inaction.”

Every year you put off investing makes your ultimate retirement goals more difficult to achieve.

Saving is route to wealth

The only way to build wealth to support your future lifestyle is to spend less than you earn and to save the difference. If you fail to do this you can’t grow rich, or even moderately wealthy.

A common misconception is that the rich are rich because they earn a lot of money, but think about it, if you earn $1 million and spend $1m you’re not rich; you are barely solvent. The rich are rich because they save a lot, which they achieve by spending less than they earn.

If saving is the route to wealth, then time is the highway that leads the way. There is no reliable, guaranteed or failsafe ‘get rich quick’ scheme, although many have put their faith in such plans only to find they are left with neither capital nor time in which to repair the damage.

There are, however, proven methods to build real wealth over time that, if you exercise patience, care and discipline, can lead to very substantial rewards down the line. The key is understanding compounding and making it work in your favour.

The power of compounding

Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding.

The secret to getting rich is the miracle of compound interest. Even modest returns can generate significant wealth given enough time, but the higher the returns the better.

For example, take 30-year-old Jonny Expat who invested $100,000 in his bank earning an average of 2% a year for 30 years. By the time he reaches his 60th birthday, that $100,000 will have become $182,000. That same $100,000, if it had been invested in mutual funds earning an average of 8% a year for 30 years, would have grown to nearly $1.1m.

Looked at another way, if Jonny had chosen to wait until he was 45 to invest his $100,000 in mutual funds, it would only grow to $330,000.

Time is the primary ingredient to the magic that is compounding as the returns are exponential.

Compounding can be made more powerful through regular investment. Investing $10,000 per year for 30 years (from the age of 35 to 65, for example) and getting an 8% average annual return would provide you with a retirement fund of $1.25m – more than four times what you would have contributed over than period.

Increase the period to 40 years and that figure leaps to over $2.9m (nearly 7.5 times more than your contributions).

Don’t delay

It is human nature to procrastinate. ‘I’m not ready’, ‘I’m due for a promotion’, “I’ll be ready next year’ are all common objections. ‘Markets are poor’ is another favourite that really concerns me: no-one can time the markets and the moment you start trying, the longer it will be before you take the plunge.

Remember that it is time in the markets, not timing of the markets that is important. If markets are volatile, get investing regularly and get dollar-cost averaging working for you.

Even single year makes a big difference. If you want to wind up with a retirement pot of $1m (which will provide roughly $40,000 per year gross income) at age 65, you’d have to save an annual $69,029 per year if you waited until age 55 to start saving (assuming annual returns of 8%). However, if you started saving at age 25 you’d only have to put away $3,860 per year.

Building wealth is easy in theory, but it is up to you to have the discipline to commit and see it through. Start early, start now, make regular investments, be patient and don’t withdraw capital. Remember that most of the magic happens at the end!

Pic credit: twobee/ FreeDigitalPhotos.net

Have you seen the power of compounding in action? Tell us your stories!

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Chartered financial planner
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