Compounding is one of the most powerful forces in mathematics and nowhere is this more evident than in Investing where it manifests itself through something called compound interest.
Albert Einstein is alleged to have once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Whether or not Einstein ever actually said this is unclear, one thing however which there can be no doubt about is the principle of the statement. No wonder Warren Buffett, the world famous Investor, called his biography Snowball. Simply build a small snowball and send it downhill and watch it grow on nothing more than its own weight.
In its simplest terms, the phrase compound interest means that you begin to earn interest on your interest, resulting in your money growing at an ever-accelerating rate. At first your returns may seem small, but if you’re patient, they’ll become enormous. For compounding to work effectively, it requires two necessary things. Firstly, Time and secondly, the re-investment of gains.
How do you make compounding work for you?
- The sooner you start, the better. Compounding is a function of the return you get and time. For most people a return of 3% to 6% percent is realistic, but time is a diminishing commodity. So the younger you are, the more time you have to really make compounding work for you, and the wealthier you can become. The simple matter of when you start saving can often outweigh how much you actually save, let’s take the example of 2 employees in the same company saving into their pensions, Tom & Mary.
Tom starts saving €5,000 per year into his pension from age 18, at age 28 he stops, he has been saving for 10 years and contributed a total of €50,000. His co-worker Mary invests the same €5,000 per year but she begins at age 28 and continues the annual €5,000 investment until she retires at age 58. Mary has invested for 30 years and contributed €150,000 in total. Mary has invested 3 times as much as Tom, yet Tom’s account has a higher value. He saved for just 10 years while Mary saved for 30 years. This is compound interest at its best, the investment return that Tom earned in his 10 early years of saving is snowballing. The effect is so drastic that Mary can’t catch up, even if she saves for an additional 20 years.
- Make regular investments – this is especially relevant in terms of your pension as this is probably the only investment you will ever do which is allowed to grow completely tax free for its entire duration, thus further enhancing the compounding effect. The more you contribute to your pension, the more you can let compounding work its magic.
- Be aware of the Tax on your Investment. Most deposit accounts will deduct DIRT on an annual basis thus reducing your potential to earn interest on your interest, avoid DIRT. A more favourable tax structure is called “Gross roll up”, this is the tax regime which is applied to most Investment funds, your Investment will be allowed to grow for up to 8 years before Exit Tax is applied. Of course the most tax efficient structure of all is your pension where your entire funds will grow tax free until your retirement.
- Be patient. Compounding only works if you allow your investment (capital) to grow. It takes time to see the wonders of compounding returns, and as you can see in the magic penny story above, most of the growth comes at the very end.
Compounding creates a snowball of money and you will reap the rewards if you start young, invest wisely and leave your money alone over the long term. Compound interest favours those that start early, which is why it pays to start now. It’s never too late to start — or too early.
Barry Kerr BBS QFA CFP® is the owner of Wealthwise Financial Planning, Block C, Hartley Business Park, Carrick on Shannon, www.wealthwise.ie. Wealthwise Financial Ltd T/A Wealthwise Financial Planning is Regulated by the central Bank of Ireland. All details and views contained within this article are for informational purposes only and does not constitute advice. Wealthwise Financial Planning makes no representations as to the accuracy, completeness or suitability of any information and will not be liable for any errors, omissions or any losses arising from its use.