Parents, if you had only had one concept to explain to your children to help them as they set out on their investment journey, it should be Compound Interest. It’s becomes even more relevant for saving when projected returns are expected to be lower.
Albert Einstein described compound interest as “the eighth wonder of the world”.
You can see why the quote is so popular. It’s the single most powerful concept to understand and experiment with to appreciate investing and long-term financial planning.
Table 1 below compounds returns over various periods using four real return assumptions (i.e. the return above inflation of 2.5%):
The results from investing $100,000 at the start are as follows:
Let’s focus for a moment on the shaded 5% results (assumes interest compounded at 5%):
If we use 7.5% real for 40 years, which investors from previous generations could have achieved just by buying residential property or a share index fund, $100,000 would be worth $1.8 million.
Table 2 shows how quickly the interest on interest dominates the interest on the original $100,000 invested. Consider how much the value of the investments increases in each decade over a 40-year period.
At the heady real return rate of 7.5%, the final decade alone grows by nearly a million dollars.
Let’s say someone inherits $100,000 at the age of 25 and wants $1 million by the time they reach 65.
With such low interest rates on offer, this is a massive issue for today’s investors. In the past, wealth could be accumulated over time by relying on high compounding returns. That’s why many older ‘average’ income earners live in multi-million-dollar homes.
Low returns require a fundamental rethink. Far more of the retirement nest egg will need to come from savings over a longer period to avoid missing a lifestyle goal.
The concept of compound interest essentially means “interest on the interest” and is one of the most powerful forces of investing. As such, it is a key concept to understand to have a successful long-term wealth strategy.
You don’t need to be wealthy to become a millionaire. You need good financial advice, solid investment performance and time to let the power of compound returns do its thing.
In this ‘save early, save often, save for a long time’ message, the last word goes to Warren Buffett, and it applies for most people, even those of average means.
To find out more about how any of these measures may be of assistance in your individual circumstances, please contact Gordon Thoms or David Conte at Calibre Private Wealth Advisers on ph. (03) 9824 2777 or email us here.
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