“Compound interest is the eighth wonder of the world. He who understands its, earns it…he who doesn’t, pays it.” ~ Albert Einstein
This point is excellently illustrated by our retirement savings. Let’s say that Bob is starting in his first job and he plans to save R500 per month. If he receives a return of 10% per year, Bob will have about R3.1 million saved in 40 years’ time. (For simplicity, the amounts in this article have been rounded down.)
If Bob stops saving after just 30 years then he will have only saved R1.1 million, which is about a third of what it will be at year 40. If he stops saving after 20 years, the value of his savings will be R380 000; about a third of what it would be after 30 years. And if he stops saving after 10 years, he will have saved R100 000; less than a third of what he could earn after 20 years. It seems amazing that in this example, the level of Bob’s savings trebles every ten years. How can this be?
The answer lies in the amazing power of compounding. By leaving his money invested, Bob is able to earn income on the income that his savings generate. The longer that this is allowed to take place, the greater the returns. This is the single most important lesson for investors, as it enables their money to grow exponentially.
Let’s, though, look at this a different way. If, after ten years, Bob changes jobs and this is his pension fund investment, the Human Resources Manager will call to ask what he wants to do with the money in his pension fund. He will have three options:
- Transfer it to his new employer’s pension fund,
- Transfer it to a retirement annuity or preservation fund in his own name, or
- Have the money paid out to him.
Most people choose option three and have the money paid out. In Bob’s case, it is R100 000. He may compare that to the potential R3.1 million that he could have after 40 years and think that R100 000 is worth nothing in comparison to the potential end value. He may think that if he takes the R100 000 after the first ten-year period, that it won’t make much difference, as he plans to carry on saving R500 per month for the next few decades.
But Bob is missing an important point. He will in fact not continue saving at the same rate the next few decades as he has to repeat the first ten-year period. This means that he is not cutting the first ten years of compounding off of his money, he will be cutting off the last ten years. In those last ten years the value of his money grows from R1.1 million to over R3.1 million. This is a difference of R2 million. By spending the R100 000 after ten years, he is fact not losing R100 000 – he is losing the R2 million’s worth of growth that he will earn from year thirty to year forty. This example explains why compounding is indeed the eighth wonder of the world.
By Paul Leonard, Citadel Advisory Partner