A quote that compound interest is “the eighth wonder of the world” is often attributed to Albert Einstein. Whether the famous physicist actually said those words is open to debate, but sentiment about the value of compound interest is not.
Capitalization is the central pillar of investing – that’s why investing works for the long term. Investopedia describes it as “the process of generating profits from the reinvested profits of an asset.” Simply, over time, you earn returns on the money previously reinvested. Or, interest on interest.
Reinvestment of returns
Reinvesting returns is essential and makes a fundamental difference. Saving 10,000 Rand with a 6% return and withdrawing your interest each year means that after 10 years you will still have 10,000 Rand, with 600 Rand each year in return (or 6,000 Rand).
But reinvest the returns and the second year you generate returns on R10 600; in the third year, you generate returns on R11,236, and so on. You earn more interest each year because the amount invested each year increases, without you making any additional investments.
Compound interest earned on the original R10,000 may not seem significant, but if applied to larger numbers, the effect of compound interest becomes substantial.
And time is everything. No wonder financial advisers urge you to start saving when you’re in your 20s or 30s. You have time on your side and that alone is half the battle won.
Time, the ally of an investor
Saving as many years as possible can have a very positive effect – thanks to compound interest. This is illustrated by the story of Xoliswa and Mark.
Imagine two university graduates, Xoliswa and Mark, who are both starting their careers.
From the age of 25, Xoliswa saves R4,000 per month in a trusted unit, but she is disciplined. Over time, the SICAV in which it has invested generates an average return of 8% per year. After a decade, at age 35, her investment will be worth R731,784. The amount she saved each month is R480,000, but the rest of that growth – R250,000 – is all due to compound interest. At this point, Xoliswa decides to stop her monthly contributions.
Letting the capitalization work its magic means that his investment will have reached 5.37 million rand by the age of 60. Remember that this is without additional contributions.
Mark, meanwhile, is 35 when he decides he needs to make sure he has some money set aside for retirement.
He also saves 4000 Rand per month in a mutual fund and also has the chance to receive an average return of 8%. He starts later than expected, but he is sure to catch up with Xoliswa: he has 25 years left before he retires.
At 60, Mark will have saved R 3.8 million and is happy. His contributions during this period will amount to 1.2 million rand, with interest totaling 2.6 million rand. The composition did the trick for him too.
But thanks to the time savings – a step ahead of 10 years – Xoliswa saved over an additional 1.5 million rand, although he only contributed 40% of Mark’s contribution (480,000 rand against 1.2 million rand). Those 10 years make a remarkable difference, and illustrate the benefit of saving – and leveraging compound interest – as early as possible.
But if you’re more like Mark and haven’t started saving yet, don’t panic. You always have time ahead of you. The most important thing is just getting started.
For more information on investing, talk to your financial advisor.
This article is part of an investment series by Discovery Invest.
Discovery Invest is a licensed financial services provider. Registration number 2007/005969/07. For more information on Discovery Invest, contact your financial advisor.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell investment funds.