Power of Compounding
Compound interest has been described by Albert Einstein as
'The most powerful force in the universe'
Compound interest is a fundamental component of wealth creation and by understanding just this one principle, you can make a significant difference to your financial independence over the long term.
Compound interest means that you receive interest, not only on your initial investment, but also on the prior interest added to your investment. Sounds simple, but not a lot of people understand how powerful it is when applied or how the total return grows exponentially the longer the time frame.
Let’s take a simple example to illustrate the point.
Say you could invest $10,000 into a managed fund at an annual interest rate of 12%. You have the option of choosing to have the interest paid to you every year or of re-investing it back into the fund. Which option would you choose?
Here’s how the investment would look after 10 year for each choice:
Interest paid out |
Interest compounded |
|||
End Year |
Investment Amount |
Interest Paid Out |
Investment Amount |
Plus Interest Re-invested |
1 |
$10,000 |
$1,200 |
$10,000 |
$1,200 |
2 |
$10,000 |
$1,200 |
$11,200 |
$1,344 |
3 |
$10,000 |
$1,200 |
$12,544 |
$1,505 |
4 |
$10,000 |
$1,200 |
$14,049 |
$1,686 |
5 |
$10,000 |
$1,200 |
$15,735 |
$1,888 |
6 |
$10,000 |
$1,200 |
$17,623 |
$2,115 |
7 |
$10,000 |
$1,200 |
$19,738 |
$2,369 |
8 |
$10,000 |
$1,200 |
$22,107 |
$2,653 |
9 |
$10,000 |
$1,200 |
$24,760 |
$2,971 |
10 |
$10,000 |
$1,200 |
$27,731 |
$3,328 |
Total interest earned |
$12,000 |
$21,058 |
As you can see, the effect of the compounding has increased the returns on your investment by $9058 ($21058 - $12000) which is better than 75% increase simply because you you earned interest on your interest.
For this comparison exercise the effect of compounding has been to significantly increase your investment return. You will need to consider the effects of tax, the risk of the investment and whether you can afford to re-invest the interest.
We talked before about exponential growth over longer timeframes so let’s look at the effects on our initial $10,000 investment over a 40 year period.
If you continued your investment for 40 years and reinvested the interest you would be $872,510 better off than if you took the interest out every year. You can see from the chart below, that compounding significantly increases your interest, through exponential growth.
What these figures are telling us is that the time factor is very important – the longer you have to compound the better off you will be. This means that it is a good idea to start saving as early as possible and even saving small amounts every week can make a huge difference.
Let’s take a look at another case study to demonstrate this:
Case Study Matthew is 20 and he has just started a new job. He has $100 a month spare which he can either spend or save. He decides to save his $1200 a year in an investment that is going to return 10% per annum. Matt’s friend Chris also started work but he decides to spend his $1200 a year but when he turns 30 he realises he might need to start saving so in the 11th year of this exercise he starts to put away $1200 a year, earning the same 10% interest. Let’s look at how much each has saved by the time they are 60.
By starting to save 10 years earlier than Chris, Matt has more than doubled the amount of savings by the time he is 60 – just over $580,000 compared to Chris’ $217,000. Matt only saved $12,000 more over the 40 years but it was the power of compound interest over that time that made the difference. |
Lessons to be learned
- Learn to live on less than you earn and invest your disposable income – 10% is an amount to aim for but start with less if that is all you can afford. Consider the concept of “paying yourself first” and perhaps set up a direct debit from your salary.
- Find investments that have a reasonable interest rate (at least above the rate of inflation) but don’t forget about risk. Make sure that the investment allows capitalisation of earnings and the more often the better. For example shares pay dividends twice a year and high interest savings accounts pay interest monthly. Don’t forget that your investments may not earn the same amount every year but it is important to aim for a high average rate of return over time.
- Seriously consider starting a regular savings plan as soon as you can to take advantage of compounding. No matter what your age and no matter how small your initial savings amount might be, the power of compounding will work for you. The sooner you start the better, as shown by our examples above. Even if you are older, the power of compounding can still work for you but of course the benefits won’t be as significant. Encourage your children to start saving at an early age.
If you would like to run some scenarios through a calculator to see what your returns might be, check out the Compound Interest calculator at the Barefoot Investor website.
If you are interested in the mathematical formula behind compound interest there is a good article in Wikipedia.