When it comes to creating wealth, there are two main rules you need to follow: First, you need to make sure that your money is not losing value due to inflation. Second, you need to take advantage of compound interest.
While these are straightforward concepts in theory, many people don’t follow them because they fall into the trap of waiting too long to start investing. In doing so, they make growing their wealth harder than it needs to be, purely because they don’t understand the power of compound investing.
Albert Einstein is reported to have said,
“Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it”.
This article will explore the power of compound interest and why starting sooner rather than later can make a significant difference in your future.
What is compound interest?
Compounding is essentially the concept of earning interest on top of interest. For example, with an online savings account that pays interest every month, you’re earning interest on top of interest if you're not withdrawing that money. This contrasts simple interest, where interest is not added to the principal, so there is no compounding. Instead, interest is paid as a one-off at the end of the investment period. The same principle also applies to shares. With shares, you earn income from dividends (distribution of company profits), which you can reinvest to acquire more shares and earn even more in dividends.
Should you invest a little now or more later?
Many clients' common dilemma is whether to wait until a better time to invest. The power of compounding, though, means that the longer you wait, the more you will need to invest and the less you will earn.
Let’s take a look at an example to illustrate this point.
Let’s say our imaginary client, Sarah, is deciding whether to invest. She is five years into her 30-year mortgage and has decided that she wants to grow her wealth over the next 25 years. She is deciding between investing $5,000 a year now for 10 years and leaving her portfolio to grow on its own or investing $10,000 a year for 10 years in 15 years. Let’s assume that Sarah’s investments achieve an average annual return of 8%.
If she chooses option one and invests $5,000 a year for 10 years, she will invest a total of $50,000, and based on an 8% return, she will have $248,000 in 25 years' time. If she chooses option two and invests $100,000 over 10 years, she will only have $156,000 in 25 years despite investing twice as much. That’s a $92,000 difference!
This difference is because her money had more time to grow in the first scenario. Take a look at the table below:
If we use the same example but the returns average at 6% per year, she will have earned close to $28,000 more by starting early. If her returns are higher and average at 9% per year, she will have earned $136,000 more.
While predicting the rate of return on any investment is nearly impossible without a crystal ball, there is one guarantee: compound interest. In other words, the key to growing your wealth lies less in the amount you invest and more in the time your money has to grow and compound over time.
Developing a growth mindset
While understanding the power of compounding is important, it is just one aspect of growing your wealth successfully. The other aspect is having the right mindset. Investments, especially shares, fluctuate in value daily and are heavily reported on by the media – especially when there is a downturn. This means that to be successful as an investor, you must have patience, resilience and confidence in your decisions. Otherwise, you will be selling your investments with every news cycle, and never giving your money the opportunity and time it needs to grow.
Fear not, however, as there are things you can do to improve your resilience and make it easier for you to stay the course and play the long game.
#1 Don’t invest money you will need
If you have money set aside or earmarked for a special occasion coming up in the next few years (whether that’s a house deposit, a holiday or a wedding!), you will sleep much better at night if you keep this money aside and in a more stable investment than the share market (such as a term deposit, high-interest savings account or your offset account if you have a mortgage).
#2 Have emergency savings
Successfully investing means being in control of deciding the best time to sell your investment and withdraw your funds. This means keeping emergency savings aside so that you aren’t forced into selling an investment at the wrong time if you need money quickly.
#3 Review your Income Protection
Income Protection is another part of your emergency backup plan. This means that if you are off work for an extended period due to medical reasons, you aren’t forced to sell your investments to pay the bills.
#4 Don’t take advice from the news
Last but not least, remember that the news cycle is all about attention-grabbing headlines. It only paints part of the picture and is not the right information source for investment decisions.
While it is tempting to wait until a later time to start investing, the power of compounding means that there is no better time than the present to start. The longer your money has to grow, the less of your own money you will need to set aside.
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What you need to know
This information is provided and produced by Lush Wealth. The advice provided is general advice only, as we did not consider your investment objectives, financial situation or particular needs in preparing it. Before making an investment decision based on this advice, you should consider how appropriate the advice is to your particular investment needs and objectives. You should also consider the relevant Product Disclosure Statement before deciding on a financial product.