Compound interest – What’s the big deal?

2018-06-20 15:43

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Albert Einstein is rumoured to have described compound interest as the 8th wonder of the world, the story goes that he went on to say, “He who understands it, earns it. He who doesn’t, pays it.” Whether this can be attributed to the great mathematician and physicist or not, the value of compound interest has been spoken about by experts in their fields. To understand the wonder of compound interest and how to make it work for you, see what a few experts say about it.

The Basics with Buffet

Ask Billionaire investor Warren Buffett for the single most powerful factor behind his success, and he’d instantly respond “compound interest” — without skipping a beat.

At a net worth of $84 billion, business magnate Buffet is currently Forbes' third wealthiest man in the world. In his documentary Becoming Warren Buffet, the 87-year-old explains the basics of compounding by using a story he heard as a child. 

A man once did something for a king and the king asked him, “What can I do for you in return?”. The man said, “Let’s take a chessboard and put one grain of wheat on the first block and double it on the second and double it on the third and so on.”

The king was shocked by this simple request and agreed. By the time he realised that 9 223 372 036 854 780 000 grains of wheat piled up on the 64th block, he was giving away his entire kingdom.

This story underlines the power of compound interest (interest on interest on interest) and is the basic principle that helped Buffet accumulate his wealth over the years.

Slow, steady and persistent

The decisive factor of a simple compound interest formula is time. The more time you give your principal investment, the more dramatic the impact of exponential returns.. Chris Eddy, 10x’s senior investment analyst and 2018 Comrades runner, compares the concept of steady investing to long distance running.  

“In investing, as in long distance running, you are best served by showing up and putting in steady, consistent effort to ensure that you go the distance,” Eddy says.

Darren Hardy, former publisher of Success magazine and author of The Compound Effect, writes that compounding can show you why big, abrupt changes rarely work in life and how you can change your life over time with the power of small steps. Darren defines the compound effect as: “The principle of reaping huge rewards from a series of small, smart choices. Success is earned in the moment to moment decisions that in themselves make no visible difference whatsoever, but the accumulated compounding effect is profound.”

He goes on to explain it's what some people have referred to as the "magic" of finance. The results it produces may look like magic, but in fact it’s the outcome of a very practical, logical, and mathematically predictable process.

So how can compound interest help me, the average investor?

The sooner you begin to contribute to a retirement fund, the longer your money works for you, and the more the net investment return contributes to your pension. Initially, returns add only a little to your total investment. But then compounding (earning a return on your return) kicks in.

Compounding acts like a snowball rolling down a mountain: it keeps growing and picking up momentum. Ultimately, the compounded investment return totally overwhelms your contributions. In numbers, say you earn a total real (after-inflation) annual return of 4% pa (net of fees of 1% pa) on your constant annual contribution. After 10 years, returns equal roughly 32% of your total contributions, after 20 years it is 74%, after 30 years 132% and after 40 years 217%. Use calculators, such as those on the 10X Investments website, to calculate the numbers for yourself.

Savings, even of small amounts on investment fees, also compound and could mean you end up with larger rewards when you retire. With compound interest, paying 1% less in fees can mean 30% more money when you stop working. Earning almost 1% higher returns can mean another nearly 30%. These seemingly insignificant amounts can add up to make the difference between a comfortable retirement or a cash-strapped one.

Find out more about making compound interest work for you by using the online calculators, or contact 10X's retirement experts for a free fee comparison. Join the One Percenters at 10X Investments, where paying less than 1% in fees can mean 60% more money at retirement. Sign up before 30 June and get 6 months entirely fee free. 

This content is sponsored by 10x and co-created with Brandstudio24 for News24.



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