What is COMPOUND INTEREST and why should you care

11/02/2019
Posted in Blog
11/02/2019 Mduduzi Luthuli

From the moment they can speak, one of the first lessons you should teach a child is the concept of saving. Put your allowance in the piggy bank, so you can afford the toy you want. Sacrifice today, so you can reap the benefits tomorrow. Delayed gratification should be a timeless notion in your home as it forms the backbone of possibly the most essential tool any investor possesses: Compound Interest.

Although not a new idea, yet an extremely powerful one, compound interest has generated wealth for companies and individuals for centuries. Although almost anyone can benefit from compound interest, many surprisingly still do not utilize it. When people think of interest, they often think of interest charged on debt as opposed to interest earned on money you’ve saved and invested. This may be dumbfounding, but compound interest stands as an opportunity to benefit immensely for anyone who does understand the concept.

Defining It

It can be defined as interest calculated on the initial principal/ capital and also on the accumulated interest of previous periods. Think of it as the cycle of earning “interest on interest”. With Compound Interest, not only are you getting interest on your initial investment capital, but you are getting interest on top of interest! It’s because of this that your wealth can grow exponentially through compound interest, and why the idea of compounding returns is like putting your money to work for you.

Determining Factors

There are four factors that determine just how great of an effect compound interest can actually have.

  1. The rate of return which, if you were to invest in stocks or bonds, would be the total profit from capital gains and dividends.
  2. The rate and timing of the taxes. If possible, it is most beneficial to pay as low of a tax as possible and wait as long as possible to pay the tax. This is why pension funds and retirement annuities are extremely important as they act as tax-deferred accounts.
  3. The length of time the money is allowed to compound. Each year the money is left alone it grows at a faster and faster pace.
  4. The size of the initial capital plays a role on how quickly compound interest can grow money. The larger the initial sum, the quicker the rate of growth.

Each of these four factors can have a tremendous effect on the rate of compounding interest and should be kept in mind when making any long-term investing decisions. Consider how  each of these factors can affect your investment returns, and don’t focus purely on the rate of return.

Although a higher rate of return can have a large effect in the long run, this is a dangerous way to think. Higher return rates can often times introduce more risk and/or volatility into investments. For compound interest to work best, each year there must be an increasing amount of capital on which to compound.

A 20% a year interest return sounds great but if that same portfolio suffers an 80% loss in any given year, that can set a portfolio back immensely as almost all the capital in which to compound upon is lost. The renowned investor Benjamin Graham understood this and warned that more money has been lost reaching for a little extra return than has been lost to speculating.

Time Value of Money

The concept of compound interest is also the foundation of the time value of money, which states that the value of money changes to a person depending upon when it is received. Earning R1, 000 today is preferable to earning R1, 000 several years from now. After all, if you have it in your hand immediately, you can invest it to generate dividends and interest income. After that, you can spend it on things you want or preferably you can pay down your debt to lower your interest expense. By postponing the receipt of the R1, 000, you are losing something economists call opportunity cost.

When you learn about the time value of money, you’ll learn the formulas that show you how to calculate compound interest. This will empower you to answer questions such as….

If I need R10 million for retirement 30 years from now, and I can save R5, 000 per month and earn 8% interest per year on my investments, will I reach my goal?”

or

I’m putting R120,000 per year into a conservative diversified portfolio that I expect to earn 7% interest on an annual basis compounded  for 18 years. How much will it be worth, when I’m ready to cash out of the investment?

Do you know the answer to either of those question? I don’t ask that to seem conceited but rather to illustrate a point. If you can’t answer such questions then how will you know if your investment strategy is worth pursuing? How can you commit to a 20 year investment plan if you can’t accurately assess if it’s even worth pursuing? You need to learn about the time value of money. This is not a concept or realm solely for financial experts, rather it is a critical concept all investors should master as to properly analyse and critique their investment strategy.

Final Thoughts

As stated by some of the world’s greatest minds, compound interest is quite possibly the easiest way to build a fortune. The beauty of it is that anyone can put this concept to work as long as they invest wisely and put time on their side.

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