“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Eistein
We’ve all heard about the effect of compounding interest. For most of us, it’s been a few years since we first heard this term in school. Let’s recap on what is meant by compounding interest…
What is Compound Interest?
Compound interest is the addition of interest to the principle sum of a loan or deposit. It is also referred to “interest on interest”. This is because the interest is reinvested, rather than paid out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. This makes your money grow at a rate significantly faster than simple interest, which is only calculated on the principle sum.
How does Compound Interest work in the long term?
Example: Bill invests R 10 000 for 25 years.
This example clearly illustrates the powerful effect of compound interest over time.
Compounding your Wealth
Most people invest in funds for the following reasons:
- Advanced Portfolio Management.
- Convenient and fair princing.
- Low barier to entry.
- Risk Reduction at a low cost.
Read More: “What does it mean to invest in an Investment Fund?“
These funds invest in different types of Assets Classes. Examples include Equities (stocks), fixed income (bonds), cash and cash equivalents, real estate, etc. Your investment fund will deliver returns in the form of interest, dividends and capital gains. These returns are volatile and will fluctuate over time. This means that the compounding effect of investing in the real world looks a bit different from the example of compound interest illustrated above.
A Practical Example:
Comparison:
- JSE All Share Index (Equities) – Black Line
- ALBI Index (Bonds) – Dark Blue Line
- STeFI Index (Cash) – Gray Line
- Allan Gray Balanced Fund (Multi-Asset Investment Fund) – Light Blue Line
10-Year Returns:
5-Year Returns:
Conclusion:
It is clear from the illustrations above that asset classes perform differently over time. It is important to align your investment goals with your investment choices. An Independent Financial Adviser can fill the role of a financial coach and help you to make informed decisions. They specialise in “looking at the big picture” and will consider additional factors like tax, estate planning, risk mitigation, etc.
Contact us to learn more about how you can use the power of compounding in your financial plan.
