Most investors understand that wealth creation is a function of investment returns and time. Of these two factors, many focus on seeking the highest possible returns. However, higher returns don’t come without higher risk which often results in high volatility. This causes stress and poor decision making, or even total capital loss.
Time is by far the more powerful driver of wealth creation. The secret lies in a concept called compound interest, which Albert Einstein famously called “the eighth wonder of the world”. He went on to say, “He who understands it, earns it; he who doesn’t, pays it.” This simple but powerful idea is the key to growing your wealth over time.
What is compound interest?
In simple terms, compound interest is the interest you earn on both your initial investment (the principal) and the accumulated interest from previous periods. This “interest on interest” effect allows your money to grow at an accelerating rate over time.
The longer your money is invested, the more dramatic the effect of compound interest becomes. That’s why starting early can make a huge difference in how much you accumulate.
The power of starting early: Sally vs. Duncan
To illustrate just how important it is to start saving early, let’s compare two hypothetical investors—Sally and Duncan—both aiming to retire at age 65. They have the same goal but take different approaches:
- Sally starts saving at age 30, investing $500 monthly at an interest rate of 6%, net of fees and taxes.
- Duncan, on the other hand, waits until age 40 to begin saving the same amount.
Here’s how their savings compare over time:
As the graph shows:
- By age 65, Sally, who started saving at 30, will have accumulated over $700,000.
- Duncan, who starts at age 40, will only have around $350,000 with the same annual contribution.
- To catch up to Sally’s balance, Duncan would need to save around $1,000 per month, double Sally’s contributions.
- Alternatively, Duncan could aim for a higher annual return of 10.4% (instead of 6%) while maintaining the same $500 per month contribution. However, this would require taking on significantly more investment risk.
Why you should start now
Whether you’re saving for retirement, a down payment on a house, or your child’s education, compound interest can help you reach your goals faster. The key is to start as early as possible and be consistent in your savings and investments.
Here are a few tips to get started:
- Start today, even if it’s a small amount.
- Reinvest your earnings to allow compound interest to do its work.
- Be patient and stay committed to your financial goals.
As Warren Buffet said:
“Time is your friend; impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market.”
Make your money work for you
Compound interest is one of the most powerful forces in wealth creation. By understanding how it works and taking advantage of it, you can make your money work for you—growing your wealth steadily over time.
Want to learn more about smart investing and retirement strategies? Call one of our advisers today on (02) 6686 6678.