The magic of Compound Interest

I’m certain we have all heard of compound interest and the benefits it provides over time.

What exactly is compound interest?

Put simply it is the concept of earning interest on your interest.

Any interest or return earned in one period is then added to your original investment and then it all earns interest in the next period and so on.

Examples of Compound Interest

  1. Let’s say you started with $500 to invest and were able to add $500 to that starting sum every year for 20 years. If that investment was invested in a simple bank account earning 3% per annum in 20 years the investment would be worth $13,838. On an initial outlay of $10,000 that’s not very exciting.
  2. If you managed a 7% per annum return instead of only 3% per annum your $10,000 outlay would be worth $21,933. Much better.
  3. Compound interest works even better with a larger initial investment. If you started with $2,000 instead of $500 and added $500 per year for 20 years AND you managed a 7% per annum return the total value will have grown to $27,737.

The above examples are deliberately simple and only take into account annual compounding where, in real investment markets, compounding is much more frequent.

How can we maximise our compound interest?

  1. Rate of return – obviously the higher the return each year the greater the effect.
  2. Amount of contribution – the bigger the better as this means there is more for returns to compound upon.
  3. Time – the longer the better as this means the compounding process of earning returns on returns has more time to work. Time also helps smooth out any volatility in returns (which are inevitable). In the examples above after 40 years the investment value of the 3% per annum portfolio will have increased to $38,832 whereas in the 7% per annum return strategy the portfolio will be worth $106,805 and the strategy with the slightly larger initial investment will be worth $129,267.

Why do investors often miss the boat on compounding returns?

Many are too conservative – lower returning defensive assets will help you avoid short term volatility but won’t build wealth over the long term.

Leaving it too late – many investors leave it too late to begin seriously saving and then don’t contribute enough initially. This makes it difficult to catch up later in life – fortunately our super system now makes saving compulsory.

Not sticking to the plan – many will begin their investment strategy with the right mix of investments only to be deterred during a period of high volatility. Many switch to cash during these times and either never switch back or do so too late.

Conclusion

Take a long term approach to investing and focus on growth assets, contribute as much as you can as early as you can. Don’t panic or abandon your strategy when things aren’t going so well and, if an investment seems too good to be true, it is.

 

 

Knight Financial Advisors Pty Ltd is a Corporate Authorised Representative of NKH Knight Holdings Pty Ltd (AFSL 438 631) ABN 30 163 152 967. The information contained herein is of a general nature only and does not constitute personal advice. You should not act on any recommendation without considering your personal needs, circumstances and objectives. We recommend you obtain professional financial advice specific to your circumstances.