One of the key ways that an investment can provide returns is through earning compound interest. Compounding is when the interest on a sum of money is added to the original amount so that the interest earned yesterday, earns interest today.
In order to reap the full benefits of compounding, a long-term investment or retirement strategy should be employed. For example, if you invest in a balanced fund, you need to be comfortable with a minimum investment period of three years.
Over this time, compounding can dramatically multiply the value to the extent that interest growth, not your contributions, forms the majority of the total investment.
A double-edged sword
While compounding can be your best friend, it can also be your worst enemy too.
The same mechanism is applied to money that is borrowed – this could be through a credit card or loan, for example. The amount of money that is owed, earns interest and based on the interest rate and time period during which you’re paying it back, compounding can make the credit cost significantly higher than the original amount you borrowed.
How compounding works
The effect that compounding may have on an investment or loan can be determined by:
- The amount of money that has been invested or borrowed.
- The time period of the investment or loan.
- The growth rate: the rate of return on the investment or the interest charged on a loan.
- The compounding frequency:
The table below uses the example of an investment of $10 000 and annual compounding to illustrate how compounding works.
|Amount of your investment||Return rate||Total amount with return earned|
|Year one||$10 000||10% annually = $1 000||$11 000|
|Year two||$11 000||10% annually = $1 100||$12 100|
|Year three||$12 100||10% annually =$1 210||$13 310|
By extrapolation, in year 20, at the same annual return rate, the original investment of $10,000 will have grown to $67,275 (a return of $57,275).
However, should you spend the annual return each year over 20 years, only your original investment of $10 000 will remain invested.
In comparison, if you add $1000 per year for 20 years to the original $10 000, you will have saved an extra $20 000, considerably less than the compound interest amount of $57 275.
How to make compounding work for you
The sooner you start saving, the more time you give the investment to earn interest through compounding. In order to get the maximum benefits, you need to be strict and not spend the returns that your investment makes before reaching your financial goal.
It needs to be reiterated that the potential for an investment to be successful is to adopt (amongst other aspects) a long-term investment strategy.
The trade-off is whether you choose instant or delayed gratification; it’s essentially a situation of cause-and-effect: If you decide to use credit you will have to pay for the benefit of instant gratification. In contrast, if you choose to save, you will be rewarded by seeing significant growth in your investment.
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