Albert Einstein is said to have called it the most powerful force in the universe, and John D Rockfeller named it the eighth wonder of the world. We call it compound interest.
Why is it regarded so highly? Most of us studied compound interest at school, so we have a pretty good idea how it works. But it’s not until you start looking at practical examples that you realise just how powerful it can be.
Imagine you are 21 again. You decide to invest $5,000 and then add to it at a rate of $1,000 a year – until you turn 30. Then you stop saving altogether and leave your nest egg alone until you turn 65.
Let’s assume you earn an average return of 8%pa (after fees and taxes) which you always reinvest. And for simplicity let’s say inflation is zero (so your real return is a healthy 8%).
Now imagine an alternative scenario.
In this version you don’t start saving until you turn 31. At 31, you put aside $5,000 and add another $1,000 each year until you turn 65. Remember you are reinvesting income, inflation is zero and you’re getting the 8% pa average return.
Which is the better strategy?
The ten year saving plan, in which you will have invested a mere $14,000 (a $5,000 initial contribution then $1,000 a year for nine years) will reap $332,413. The 35 year plan, in which you will have invested $39,000 – nearly three times as much – earns you considerably less: $227,077.
The bad news is time flies. The good news is when it comes to compounding time is on your side.
Content for this article first appeared in Ten Investing Truths, BT Financial Group