Time is both an ally and enemy

2012-06-23 10:48

The aim of investing is to make your money grow, which takes time. But in the world of investing, time is both an ally and an enemy.

Time allows your money to grow, and the power of compounding allows it to grow exponentially.

Sometimes referred to as the eighth wonder of the world, compounding makes your money work for you by earning returns today on the returns you earned yesterday.

To enjoy the benefits of compounding, reinvest the returns you earn instead of spending them. This allows both the original investment and the returns you’ve earned to grow over time.

Consider an investment of R10 000 that you decide to invest for 12 years. Assume that each year it earns a return of 10%, or R1 000. If you spend the R1 000 each year, after 12 years you will still only have R10 000.

Alternatively, if you reinvest what you earn each year you’ll end up with a far larger amount.

If compounding didn’t exist, by reinvesting your R1 000 each year you’d end up with an extra R12 000, bringing your total investment to R22 000.

But through the power of compounding you’ll actually end up with R31 300.

How does this work? By reinvesting the R1 000 you earned in the first year of your investment, your original R10 000 grows to R11 000. And if that returns 10% the following year, you earn R1 100 and your investment is worth R12 100.

In year three, if you continued to earn 10%, your return would be R1 210, bringing your total to R13 310, and so forth.

This demonstrates the significant difference compounding makes to your investment over time, as both the capital available and the amount earned are growing.

But time is also an enemy because it erodes the value of your money and you’re able to buy less with the same amount of money. This is called inflation.

The returns on your investment should be at least enough to compensate you for the length of time that you invest so that the value of your money is maintained.

If inflation is 6% a year, for example, your investments have to grow by more than 6% each year before you achieve any real return.

Inflation of 6% a year would reduce your final overall investment amount achieved from R31 380 to R16 010 in terms of actual buying power. In other words, in 12 years you will need R31 380 to buy the same amount of goods R16 010 buys today.

Wealth is measured in buying power, not in sums of money, and often a significant portion of any investment return you earn compensates for inflation first.

When evaluating your returns it’s important to look at the real return, which is your return after inflation – not the nominal return, which is the growth on your investment before the effects of inflation are considered.

» Ngwane is head of emerging markets at Allan Gray 

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