Saving and the power of compound returns

Compound returns are an exceptionally powerful financial force and are the cornerstone to successful investing. Albert Einstein famously said “Compound returns are the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

The earlier you start saving, the bigger the benefit of this ‘phenomenon’ that is compound returns and the better chance you will have in achieving financial security. It’s about earning new returns on existing returns similar to the effects of a growing snowball.

It can be difficult to truly understand the advantages of compounding as initially, there is very little benefit. But the longer you save, the benefit grows exponentially, which we demonstrate in two examples below:

Example 1:

If you invest an amount that yields a 10% return over a 5-year period, your money will multiply by 1.6 times. If you invest the same amount of money for 10 times longer (50 years), your money will not merely multiply by 16 times. In fact, your money will multiply by 117 times over.

This simple example illustrates the exponential nature of compound returns. The longer you are invested, the quicker your money will multiply.

Example 2:

This example looks at a typical 30-year retirement savings plan. It assumes monthly contributions are made towards a fund with a 5% annual increase on contributions.

The graphs below are divided into 4 sections.

1. Contributions made towards the fund from year 1-10 (10 years)
2. Contributions made towards the fund from year 11-30 (20 years)
3. Growth on the first 10 years’ contributions
4. Growth on the proceeding 20 years’ worth of contributions.

Graph 1

It is astonishing that after 30 years 45% of the end fund value comes from 5% of the capital invested (first 10 years’ contributions), and only 30% of the end fund value comes from 20% of the capital invested (contributions in the proceeding 20-years).

One would assume that the largest section of the graphs would be related to the longer time frame (11–30-years), however this is not the case. The growth on the first 10 years’ worth of contributions is comfortably the largest section, which highlights the power of time in the market and compound returns.

As can be seen from graph 2 below, the real benefit of compounding can often only be realized after 10+ years of investing. The exponential nature of compounding growth becomes evident (yellow bars) as the value grows, illustrated in the steepening of the curve.

Graph 2

To further enhance your investment growth, the appropriate structuring of your investment is as important. You need to ensure that:

1. The correct investment vehicles are selected to minimise your tax liabilities i.e. Capital Gains Tax.
2. The correct investment strategy is selected to maximise returns and achieve your objectives.
3. A Financial Plan is constructed to give you the best possible chance of success in achieving your life goals and long-term financial security.

Speak to one of our client portfolio managers and find out how you can start a journey to achieving financial security or click here to begin your financial plan.