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The Power of Compounding

In this article:

Why start today?

Albert Einstein is often credited with saying ‘Compound interest is the eighth wonder of the world’. And he was a genius, so he must be right.

If you’re not sure what compounding is, consider  it like this. You invest money, and make returns on it – think of the returns as ‘free money’. Then you make a return on both the initial amount, plus the returns. So you get even more ‘free money’.

Put another way, wouldn’t you rather earn 10% on $1.10, than on $1?

Well, if you invested $1 and received a 10% return last year, you get to benefit from compounding.

Now, that 10c doesn’t sound like a big deal in the scheme of things. And at first, it’s not.

But the magical element of compounding is the effect of time. At first, the free money is just a nice piece of icing on the investing cake.

But with time, it comes to be the cake itself, and the money you put in becomes the jam, cream and icing.

The other interesting piece of the puzzle – or perhaps cake – is that doing more early on, means you can do less later on.

Our friends at Katana Asset Management recently ran an interesting experiment on this topic - with surprising results!

Let’s take two women: Sally and Sarah.

Sally is a saver, and every year adds $10,000 to a share portfolio. Let’s assume the return is 10%*, which is the historical average of the ASX Accumulation Index (bearing in mind, of course, that past returns don’t predict future ones).

Sarah is a spender, and instead spends that money on lifestyle perks.

After five years, Sarah the spender has some beautiful shoes, an extensive wardrobe and a lovely car. Sally has none of these, but she does have $61,051 saved in a share portfolio.

At this point, Sally decides that she’s sick of her frugal ways, and stops investing the $10,000 a year. She leaves the shares to compound, taking the dividends and capital growth, but not adding any more money.

Sarah, on the other hand, has a wake-up call and decides to trade in many of her shopaholic ways putting aside $10,000 a year. But at the end of the day who’s better off?

Who's the better Saver? After 10 years who do you think has saved the most? The poll is closed.
Sally
 
47
Sarah
 
6

If you guessed Sally then you're right! 

What happens to Sarah then? Can she ever catch up to Sally?

 

Of course! But it would take her at least 10 years of investing $10,000 each year.  So, by the time Sarah caught up she would've invested twice as much as Sally and it would've taken twice as long.

 

compound-graph.png

How can you use compound interest to boost your savings?

1. Start today - when it comes to compound interest and your savings, time is your best friend. The sooner you start saving, the longer your money is earning interest for you.

2. Pay off any debt - while time is your best friend when you're saving, it can be your worst enemy when it comes to debt. In the same way savings compound over time, debt does too. So make paying off any compounding debts like credit cards a top priority.

3. Be patient -  while compound interest won't get you rich quick, it can set you up in the long-run. So, don’t be disheartened if you don't see results right away.

*Source: Katana Asset Management Ltd (2018). The Power of Compounding - The Power of Now. Yellow Brick Road Annual Conference.

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