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Compound interest - a simple yet powerful strategy

  • Monday, February 08, 2016
  • Collins Mann

Despite predictions to the contrary, the post-GFC share market is as volatile as ever. What does this mean for your investments? Well, it’s near-impossible to read the share market at the best of times and our experience suggests you don’t even try. Luckily, there’s a sound alternative - take advantage of a simple yet powerful strategy that history has proven to be an effective method for building wealth, regardless of market volatility.

* Most of us are familiar with the idea of interest. If you put $1,000 into a savings account with an annual interest rate of 10%, after one year you will have your original $1,000 plus another $100 that you earned in interest, or $1,100.

That interest starts compounding the next year. In year two you’ll earn another 10% interest on your account balance, so another $100 for the $1,000 you had in the account, plus $10 for the extra $100 you earned the year before. In other words, after one year your $1,000 becomes $1,100. After two years, it becomes $1,210.

Essentially, you’re earning interest on your interest – this is compound interest. If you increase your savings rate dramatically from today, every dollar you set aside rather than spend now will be two dollars in seven to 10 years’ time, thanks to the power of compound interest.

Now, an extra $10 in your pocket might not sound that impressive, but when you apply the same principle to larger numbers, you can really see the difference it makes.

Here’s an example. A client’s mother’s estate invested $20,000 for her grandchild with the intention of this child accessing the funds when she turned 18. The money was invested in 2003 into a diversified portfolio of blue chip shares on a dividend reinvestment program. The investment remained untouched throughout the GFC, with any dividends reinvested into the portfolio. Seven years later when the child turned 18, the portfolio had grown to over $67,000, representing a return of 12% per annum or a compounding annual rate of 12%. And this was over the period of the GFC downturn!

Beyond the fact that this money was left alone for seven years to benefit from potential growth, because the estate allowed the dividends to be reinvested, the portfolio also benefited from the power of compound interest.

This is the strategy of regularly investing into assets. Investing regularly over time is the very opposite of trying to time markets, which is hard (perhaps impossible) to do at the best of times. (Even harder during periods of extraordinary ups and downs.) Instead, because you are regularly investing, if markets are up you can say, “Great – my portfolio is going well”. When markets are down you can say, “Great – I’m buying more assets at low prices”. (And when the markets rise again, you will reap the benefits.)

Investing regularly takes the pressure out of having to call the bottom of the market cycle, while regularly buying assets at much lower prices than 12 months ago.

And if you leave your investments to compound on their own, they will double every seven to 10 years, a phenomenon proven through history.

* This post is an extract from our book,They said the World was my Oyster but someone Stole the Pearl, A Baby Boomer's guide to living a life of choice not compromise by Markham Collins & Russell Mann, available from mid-2016.

Please contact Collins Mann on 07 3251 3200 or email admin@collinsmann.com.au to find out more about the role of compound interest in building wealth as part of your own financial plan.

Collins Mann ABN 88 098 705 152 is a Corporate Authorised Representative of Hunter Green Pty Ltd AFSL No. 225962. Managing Director Russell Mann (Authorised Representative No. 273590) is an authorised representative of Hunter Green Pty Ltd ABN 12 087 491 629 which is the holder of Australian Financial Services Licence No. 225962.

The information contained within this website does not consider your personal circumstances and is of a general nature only. You should not act on it without first obtaining professional financial advice specific to your circumstances. This website holds information for Australian Residents only.