Friday, 29 January 2010

Compounding: your ultimate friend

If inflation is your ultimate enemy, compounding is your ultimate friend.

Einstein even called it the eighth wonder of the world - and being the genius he was, he would have known!

Compounding is the best weapon in your arsenal, the one thing that can make your money grow, despite inflation.

Compounding simply means that the returns on the investment grow too, and not only the capital.  It is growth on growth, or interest on interest.

The longer you invest, the more your money will grow.  That is why time is important, and the earlier you start investing the more you will earn.

Delaying your investments is as bad as not investing at all.

Example of Ann and Peter, two young people.

Ann saves $500 a year.  She starts when she is 15 years old and invests in the stock market for 10 years at a return of 20% a year. After 10 years she stops adding money to her nest egg.

Her friend, Peter, only starts to save when he is 40 years old.  After initially squandering his income rashly, Peter starts saving $40,000 a year for 25 years, also at a return of 20%.

Who do you think has the most money at retirement?
  • The total amount of $5000 that Ann had saved over 10 years, gave her a grand total of $22.9 million at the age of 65.
  • Peter on the other hand, battled to save a total of $1 million and ended up with $22.7 million.
Neither of them will have any financial problems, but the point is that Ann's money grew for 50 years - twice as long as Peter's did, and with much less effort.

How did Ann achieve this?  Not because of:
  • the rate of return:  both earned the same return on their investment, nor
  • the capital she put in:  Peter put in far more.

But because of:
  • the time factor.  Over time, Ann had growth on her money and on her returns.  Compounding is a winning recipe.

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