The magic of compounding in investment: how it works

Earn more interest each year without making any additional investments

There is a parable of a king who lost his kingdom, and it all started with a promise of a single grain of rice. The king, excited about the game of chess, offered one wish to the inventor of the game. The sage inventor asked the king to place one grain on rice on the first square of the chessboard, two on the second, four on the third and so on – and to keep doubling the grains on each of the subsequent 64 squares of the chess board.

Surprised that the inventor did not ask for money or jewels, the king agreed, not understanding the impact of what, at face value, appeared to be a simple request. The first few squares cost the king one grain, then two, then four. By the end of the first row, he was up to 128 grains of rice. But in the second row, the grains of rice grew exponentially. By the 21st square, he owed more than a million grains; by the 41st row, he was in for more than a trillion grains. When the 64th square was reached, the inventor was owed more than 18-trillion grains of rice. And so, as the parable goes, the king bankrupted his kingdom by granting one simple request. What the inventor did by asking for double the value in each square on the chess board was putting compounding into effect. Replace the grain of rice in this example with money and it illustrates how quickly your investments can grow thanks to compounding. The power of compound interest Compound interest is the central pillar of investing. It is why investing works so well over the long term. If you saved R10,000 at a return of 6% and withdrew your interest at the end of every year, by the end of 10 years you would still have R10,000 and would have drawn the interest portion of R600 each year – or, in total, R6,000 over the 10-year period. Perhaps you spent the R600 in interest your money earned each year. That would be a pity because you would have lost out on the opportunity to earn interest on interest. On the other hand, if you added the R600 interest you earned to your capital of R10,000, you would start the second year with R10,600 and earn interest on both your original R10,000 and on the interest earned in the previous year.

By reinvesting your returns, in year two you would generate returns on R10,600 and, by year three, returns on R11,236. Fast forward to year five and you would generate returns on R12,625. The compound interest gained on the initial amount of R10,000 may not seem significant, but when applied to larger figures the effect is substantial. Consider that after 10 years your investment will be worth R17,908 and, after 20 years, you would be sitting pretty with R32,071 – all of this from your single investment sum of R10,000. That is what is referred to as the power of compound interest. In short, you are earning more interest each year because the amount invested each year is increasing, without you making any additional investments. Timing is everything The longer your money is invested, the higher the impact of compound interest – so time is key. Enter the Rule of 72. This is a shortcut to estimate the number of years required to double your money at a given annual rate of return. The calculation is to divide 72 by the percentage rate of return. For instance, if you invested R100 today and earned 6% a year on your money, it would take about 12 years for the R100 to grow to R200 (72/6 = 12). As time cannot be manufactured, the only way to maximise returns is to start saving as young as possible – for practical reasons, it means starting when you start working and earning an income. Consider the example of two university graduates, Xoliswa and Mark, who are both starting their careers. From age 25, Xoliswa saves R1,000 a month in a unit. Over time, the unit trust in which she has invested generates a return of 8% per year on average. After a decade, by age 35, her investment will be worth R181,283. The amount she’s saved every month totals R120,000 but the rest of that growth – R61,283 – is all due to compound interest. At this point, Xoliswa decides to stop her monthly contributions.

Leaving compounding to work its magic means her investment will have grown to R1.24-million by age 60. Remember, this is with no additional contributions. Mark, on the other hand, is 35 when he decides he needs to make sure he has money saved for retirement. He also saves R1,000 a month in a unit trust and is also lucky enough to receive an average return of 8%. He is starting later than planned, but he’s certain he will catch up to Xoliswa – he has 25 years until he retires. By age 60, Mark will have saved R914,839, and he is happy. His contributions over this time will amount to R300,000, with interest totalling R614,839. Compounding did the trick for him too. But because of the benefit of time – a head start of 10 years – Xoliswa has saved an additional amount of more than R326,000, despite contributing only 40% of what Mark contributed (R120,000 versus R300,000). Those 10 years make a remarkable difference and illustrate the benefit of saving – and putting compound interest to work – as early as possible. Never too late to start Retirement may seem a long way off if you have just started your working career, so why worry about how much money you need when you retire? If you are in your 20s and 30s, you have time to build up a retirement nest egg – and you have a powerful friend called compound interest, which is a smart name for earning interest on interest. Even if you are already in your 30s or 40s, it is never too late to start saving for your retirement, but the younger you are when you start, the more you stand to benefit and the less money you need to put away each month compared with somebody starting to save in later years. It’s all about allowing time for your money to grow. A good way to save is to sign a monthly debit order towards an investment when you start working. With this manner of saving, you get used to not having the money available to spend on other things. Set the date for the debit order to be deducted from your bank account as close as possible to the day you get paid to avoid your debit orders bouncing due to a lack of funds in your account. The penalty fees charged by banks on bounced debit orders are high. The power of compound interest can be used to save for any goal: a house, a dream holiday, your children’s education or retirement. There are a range of investment products you can use to start saving: anything from a bank savings account to unit trusts and retirement annuities. The bottom line simply is to get started.