When you invest over a period of time, compound interest is your best friend. In effect, it means you are earning interest not just on your own capital, but also on the interest you’ve already earned. Over the long term, you might call it, “interest on interest on interest…” or more simply, “free money”! So how do you get this free money?
I = P(1+r)n-P
Don’t worry, we’ll do the maths for you, but this little formula contains a power that Albert Einstein once labelled “the most powerful force in the universe”. It calculates your net profit when you earn interest on the interest. That’s what compounding is all about.
A simple start
Imagine you place $100 in an investment that earns 10% p.a. At the end of one year, you’ve earned $10. That’s simple interest. Now if you were to re-invest that $10 of interest at the end of the first year you will have $110. Leaving it invested at 10% p.a., you will earn interest of $11 in the second year, bringing the total in the account to $121. If you keep going for 10 years, your investment will grow to almost $271 – that’s your original $100 plus $171 in interest.
Time is money – literally
This example may not seem so impressive, but the power of compound interest really shines over the long term. A child born today could easily live to 100. Our initial $100 investment left to compound untouched at 10%, for 100 years, would grow to $2,113,241! Even on such a small initial investment, that’s incredible, wouldn’t you agree?
Here’s another example, this time we’ll add some regular deposits. Once again, we start with our initial deposit of $100 but this time we can afford to add an additional $100 each week to our investment account, earning 6% p.a. Our plan is to continue this from age 35 till 55, 20yrs in total. Let’s take a closer look, over the 20 years you have personally added $104,100 but with the help of our new best friend, compound interest, you have an additional $96,449 Hooray, free money! Bringing the balance of your savings to $200,549.
A couple of drags
We also have to take tax and inflation into account. They act as drags on investment performance. Generally speaking the more tax you pay, or the higher inflation is the lower your real returns will be.
For example, let’s assume investment earnings remain at 10% p.a. and are fully taxable. If you incur tax at 34.5% p.a., over 30 years your $100 will grow to $710 after tax. If you take the same example, but you incur tax at 19% p.a. your $100 will grow to $1,127 after tax.
As for inflation, although we are currently experiencing very low inflation, nobody knows how long this will last. If it reaches the Reserve Bank’s target of 3% p.a, you will need $2.43 in 30 years’ time to buy something that costs $1.00 today.
There are many ways of minimising the effects of tax and inflation. Picking the right tax environment is clearly important. Capital gains are only taxed when an investment is sold, so growth assets have an advantage over those that only produce income. Investments that are designed to grow in value also tend to cope better with inflation.
Within this article, we’ve based our calculations on an interest rate of 10% p.a. (which helps to make the maths easy!) In the real world any investment that has the chance to earn 10% p.a. may be quite risky.
Always remember, seeking higher returns generally involves taking higher risks but some of those risks can be managed with an effective and professionally constructed investment strategy.
If you want to take advantage of “the most powerful force in the universe”, we can help, get in touch today.
Thanks for taking the time to read this post, if you have any question or would like to make a comment please feel free.
*Assumption on calculations: interest is compounded monthly.
This article is for information purposes only and does not provide advice in any form. It does not take into account any person’s objectives, financial situation or needs.
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