Investment Research Group
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The power of compounding can be seen in a compound interest graph, which bends upwards like a boomerang as interest is earned on interest previously earned, as well as on the principle amount, providing exceptional returns. By contrast a simple interest graph, where you take out the interest every year, is a straight line that runs slightly ahead of inflation, if you are lucky. Compounding works equally well with the share market, where you reinvest your annual dividend instead of taking it out.
This concept of compounding when combined with a long time frame is what successful investment is all about. It turns a college kid investing a pathetic amount of money every month, but doing so religiously, into an eventual millionaire.
The US investment portal, Motley Fool, gives the following example of the surprising results you get when you let time work for you.
"Two 51-year-olds are talking at a party about their pension plan," it starts.
EarlyBird Johnson: I've earned a compounded rate of 8% over the past 30 years. LateComer Larry: What a coincidence, so have I! EarlyBird: Yes, I started contributing $2,500 a year when I was 21, but had to stop when I was 30. I've not contributed since, although the money continued to grow in my account. LateComer: I, too, contributed $2,500 a year! However, I didn't start until I was 30. So, now that we're both 51, I've been contributing for 21 years, and you contributed only nine years. How much is in your account? EarlyBird: Let's see... $169,723. How much is in yours? LateComer (stunned): Uh.... just $136,142.
"For, you see, gentle investor, the nine-year penalty is even more severe than you think. EarlyBird contributed a total of just $22,500 over the nine years, while LateComer shelled out $62,500 over 21 years -- and still came up well short."
In a way, if we were as disciplined about investment as we are about Lotto, we couldn’t go wrong. With Lotto we are prepared to pay $10 without fail into a Lotto shop for much of our working life. If we are realistic, we would conclude our chance of winning secondary prizes on Lotto are, at best, equal to 50% of our investment. We don’t count the 3m to one shot at the big prize because it’s just not going to happen.
Let's say you spend $10 a week on lottery tickets. After 10 years, the $5,200 you "invested" will have netted you about $2,600 in losses. If you'd dropped that $10 a week into an index fund that earned 10% annually, however, you would have about $9,116 in your account -- meaning you're up $3,916 instead of down $2,600. That means our investor has $6,516 more than our lotto player.
That’s fine, but the results only become really dramatic as time rolls on. After 20 years, your Lotto money has accumulated $32,761. After 50, that $520 in yearly contributions has ballooned into $665,756.
The problem with articles about the time value of money is that to many, they are depressing. They remind many how late they are in the investment cycle. However, they also provide an idea for a great gift for your children – a drip-fed investment scheme where returns are never removed. You feed it in the early years and then teach them the discipline of carrying on.
