Compound interest is a concept that comes with many labels. Some call it the secret to doubling your money. Some call it the ultimate set-and-forget investment strategy. Albert Einstein himself called it the 8th wonder of the world. But let’s call it what it really is: a regularly underused way to build your wealth.
“It sounds so simple, it almost feels like it’s not true,” says Brendan Doggett, Country Manager (Australia) of investing business Shares.
“But when you plug in numbers, you’re like, ‘Really? $10…$10…$10…where do you get that?’ And it adds up.”
Here’s a quick and easy breakdown of everything you need to know about compound interest from the man himself:
What is compound interest?
The other quote from Einstein (allegedly) that helps explain it: “He who understands it, wins it. Whoever doesn’t, pays. Compound interest and the idea behind it are very easy to know when you pay it, like with a credit card (it’s interest on interest).
Benjamin Franklin also explains it quite easily: “Compound interest is when money makes money. And that money then makes money. And then money from that money makes money. So that’s the correct version of the interest on your credit card.
By way of example – and without going into the calculations of all this – we all baked bread during confinement. Compound interest is like your sourdough starter. You do it and it continues to grow and expand and you don’t have to do anything else. That’s the non-financial way to describe it.
Another example that people use when talking about compound interest is the snowball. At first it starts very slowly, because the quantities are small, but over time it becomes huge.
Compound interest formula
- A = Final amount
- P = initial principal
- r = interest rate
- n – Number of times interest is applied per period
- t = number of time periods elapsed
The Rule of 72
The calculation of compound interest is the rule of 72. This is the time it would take for your money to double if you did nothing. If you divide 72 by the interest rate you get, that’s how long it takes to double your money without adding anything more.
Compound interest is one thing, but if you invest in the stock market, you have access to compound returns, i.e. the increase in the price of company shares and the dividends they may pay . According to the “S&P/ASX 200 Fact Sheet,” dated June 30, 2021. The ASX 200 total return was 9.26% over 10 years through the end of June 2022. This means that approximately all 7.7 years, your money doubles if you had, say, an ETF linked to the ASX 200.
Compound interest in action
ASIC has a very good website: smart money. There is a compound interest calculator so those of you playing the game can follow the next example using the 9.26% return from the example above with annual compounding.
If you invested $10 a week from birth to age 18, you would have invested $9,360, but you would also have earned $12,714 in interest.
And if you go to 30, you would have invested $15,600 and earned $58,942 in interest.
Go to 50 and you would have invested $26,000…your investment becomes $460,670. Nearly half a million for $26,000 is pretty impressive.
When Einstein talked about the 8th wonder of the world, he was right. Because it’s money for jam, money for doing nothing. This cumulative effect is like magic.
Where to put your money
Conventional wisdom holds that you have access to the magic of compound interest by putting your money in a bank account.
The interest rate you get is important. If you look at some savings accounts right now, for the privilege of keeping your money, you can get 0.25%. This is usually an introductory rate that reverts to a lower base rate after a period of time. With these rates, compound interest won’t give you the magic you want.
Whereas if you step into the equity market, the ten-year average net total return of the ASX 200 was 9.26% including dividends. Of course, there are peaks and troughs over time. But that’s the average. And if you invest money regularly and keep reinvesting those returns, it can turn into a big return.
Of course, there is a risk in the market. Using ETFs is a way to diversify that risk across companies, sectors, themes, and countries without thinking too much about it.
How to Make the Most of Compound Returns for the Newbie Investor
It all comes down to investing regularly and setting long-term investment goals for yourself. And the sooner you put in the money, the better. When is the best time to invest? 20 years ago. When is the second best time to invest? Now. It’s never too late. When it comes to compounding benefits, it’s all about time in market, not market timing.
But what does this look like in practice? With the ASX, companies sometimes pay dividends, and some may even pay dividends twice a year. The more dividends you receive and reinvest, the more you invest in your future. Reinvesting your dividends helps you compound your returns.
There are also features like auto investing, something that just launched on the Sharesies platform. You choose a pre-made or DIY investment package, an amount you want to invest, and a frequency you want that investment to be made. The Sharesies platform basically does everything for you. And if you leave your returns in your Sharesies portfolio, you can continue to reinvest and accumulate them.
The other beauty of something like auto investing is that it could average the stock price you pay over time, but also trick you into investing habitually, for the long haul. If you can put in a lump sum to start, that’s great too, because it gets money into the market sooner.
What else should you consider before embarking on your investing journey in relation to compound returns?
- Check your financial health and pay off your debts if you can
- Calculate how much money you need to pay your bills, live your life and sort out the money you have left to invest
- But also start saving as much as you can, as regularly as possible – set goals and a strategy that works for you and your situation.
- Don’t panic…sometimes markets go up, sometimes markets go down. If you’re worried, revise your strategy and confirm that it still fits your personal situation.
- If you invest regularly, it does what is called dollar cost averaging which can even out peaks and troughs in stock prices.
“You don’t have to be a professional stock picker, you just need to invest regularly and hold. This is the secret to wealth creation, some would say.
All investing involves risk. T&Cs and fees apply for use of the platform provided by Sharesies Limited. $10 applies to new accounts only. Promotion T&Cs apply and for use of the platform provided by Sharesies Limited. This article is sponsored by Sharesies AU Pty Limited, as an authorised representative of Sanlam Private Wealth Pty Limited (AFSL No. 337927). This is not financial advice and the information provided in this article has been prepared without taking into account your objectives, financial situation or needs. Speak to a licensed financial advisor for advice specific to your circumstances. Image shown does not represent a real portfolio.