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 investing strategy. Albert Einstein himself called it the 8th wonder of the world. But let’s call it what it really is: a regularly underutilised way of building your wealth.
“It feels so simple, it almost feels like it’s not true,” explains Brendan Doggett, Country Manager (Australia) of investing business Sharesies.
“But when you plug in some numbers, you look back like, ‘Really? $10… $10… $10… where do you get that?’ And it adds up.”
Here’s a quick ‘n’ easy breakdown of everything you need to know about compound interest from the man himself:
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What is compound interest?
The other quote from Einstein (allegedly) that helps explain it: “He who understands it, earns it. He who doesn’t, pays it.” Compound interest and the idea behind it is very easy to know when you’re paying it, like with a credit card (that’s interest on interest).
Benjamin Franklin also explains it pretty easily: “Compound interest is when money makes money. And that money then makes money. And then that money’s money makes money.” So it’s the good version of interest on your credit card.
As an example – and without getting into the math of all that – we’ve all been baking bread during lockdown. Compound interest is like your sourdough starter. You make it and it keeps growing and expanding and you don’t need to do anything else. That’s the non-financial way of describing it.
Another example people use when they talk about compound interest is the snowball. In the beginning, it starts off really slow, because the amounts are small, but over time, it gets to a massive amount.
Compound Interest Formula
- A = Final Amount
- P = Initial Principal
- r = Interest Rate
- n – Number of times interest applied per time period
- t = Number of time periods elapsed
The Rule of 72
The math behind compound interest is the Rule of 72. It’s all about how long it’d take for your money to double if you do nothing. If you divide 72 by the interest rate you’re getting, that’s how long it takes to double your money without you adding anything extra to it.
Compounding interest is one thing but if you invest in the share market you have access to compounding returns which is the increase in companies’ share prices and any dividends that they may pay. According to the “S&P/ASX 200 Fact Sheet,” dated June 30. 2021. The total return from the ASX 200 was 9.26% over 10 years to end-June 2022. Meaning that approximately every 7.7 years, your money doubles if you had, say, an ETF that was tied to the ASX 200.
Compound interest in action
ASIC has a really good website: Money Smart. There’s a compounding interest calculator on there so those of you playing along can follow the following example using the 9.26% return from the example above with annual compounding.
If you invest $10 a week from birth, at the age of 18, you would’ve put in $9,360 – but you would’ve also earned $12,714 worth of interest.
And if you jump forward to 30, you would’ve put in $15,600 and you would’ve earned $58,942 worth of interest.
Jump forward to 50 and you would’ve put in $26,000… your investment becomes $460,670. Close to half a million for $26,000 – that’s pretty impressive.
When Einstein talked about the 8th wonder of the world, he was right. Because that’s money for jam, money for doing nothing. That compounding effect is akin to magic.
Where to put your money
The traditional wisdom has been you get access to the magic of compounding interest from putting your money in a bank account.
The interest rate you get is important. If you look at some savings accounts at the moment, for the privilege of keeping your money, you may get 0.25%. This is generally an introductory rate that reverts to a lower base rate after a period of time. With those rates, compound interest isn’t going to give you the magic you want.
Whereas if you go into the share market, the average net total return of the ASX 200 over ten years was 9.26% including dividends. Of course, there are peaks and troughs over time. But that’s the average. And if you regularly put money in and keep re-investing those returns, that can turn into a significant return.
Of course, there’s risk in the market. Using ETFs is one way of diversifying that risk across companies, sectors, themes, and countries without thinking too much about it.
How to make the most of compound returns for the rookie investor
It’s all about the regularity of putting money in and setting long-term investing goals for yourself. And the earlier you put money in, the better. When’s the best time to invest? 20 years ago. When’s the second-best time to invest? Now. It’s never too late. When it comes to the benefits from compounding, it’s about time in the market, not timing the market.
But what does that look like in practice? With the ASX, companies sometimes pay dividends, and some may even pay dividends two times a year. The more dividends you get and reinvest, the more you’re investing in your future. Reinvesting your dividends helps you compound your returns.
There are also features like auto-invest, something that just launched on the Sharesies platform. You choose a pre-made or DIY investment pack, an amount you want to invest, and a frequency you want that investment to be made. The Sharesies platform essentially does it all for you. And if you leave your returns in your Sharesies Wallet, you can keep reinvesting them and compounding.
The other beauty of something like auto-invest is that it could average out the share price you’re paying over time, but also gets you to be investing habitually, for the long-term. If you can put a lump sum in to start off with, that’s awesome too, because that gets money in the market earlier.
What else should you consider before undertaking your investing journey vis-a-vis compound returns?
- Audit your financial health and pay down debt if you can
- Work out how much money you need to pay your bills, live your life, & sort out what spare money you have left for investing
- But also start saving as much as you can, as regularly as you can – set goals and a strategy that works for you and your circumstances.
- Don’t panic… sometimes the markets go up, sometimes the markets go down. If you’re worried, review your strategy and confirm it still lines up with your personal circumstances.
- If you’re regularly investing, it does this thing called dollar-cost averaging which can even out those peaks & troughs of share prices.
“You don’t have to be a professional stock picker, you just have to invest regularly and hold. That’s the secret to building wealth, some would say.”
Brendan Doggett
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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.
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