The power of Compounding

Investors’ decisions – both conscious and subconscious – have an important bearing on their long-term wealth. As a result, Colonial First State is pleased to introduce a series of short papers relating to various aspects of behavioural investing. In this paper, we examine the power of compounding. 

Compounding isn’t a new concept – many of us will remember studying it back in our school days. Legendary scientist Albert Einstein famously called it ‘the most powerful force in the universe’, while American business magnate John D Rockefeller suggested compounding is the ‘eighth wonder of the world’.

These might sound like bold claims, but the power of compounding on an investment portfolio should certainly not be underestimated. 

What is compounding?

In simple terms, compounding is the process whereby returns made on an investment are reinvested in order to generate subsequent returns of their own.

The concept of compounding is best illustrated using an example. Twins Annie and Vanessa both allocated $10,000 to the same interest-bearing investment on their 25th birthday. For simplicity, let’s assume the investment pays interest of 5% per year. Annie reinvests all of her interest every year, while Vanessa banks the $500 each year and spends it on everyday living expenses. Let’s see how their investments had fared by their 45th birthdays. 

Vanessa earned $500 interest each and every year for the 20 year period – a total of $10,000. Of course she still had her original $10,000 investment as well. 

Annie, on the other hand, saw her investment grow to more than $26,000 by reinvesting her interest. The additional $6,000 she earned over and above Vanessa highlights the power of compounding. You can see from the table that Annie’s investment is now earning her $1,263 per year, while Vanessa’s investment is still earning her only $500. This differential would continue to grow over time if the sisters remained invested. 

Make compounding work even harder for you

The power of compounding can be magni ed if you make small regular contributions to your investment. Let’s look at another example to highlight the concept.
Brothers Jim, Dan and Tom all decided to invest $10,000 in the same managed fund for 10 years. Over that time the fund returned an average of 8% pa.

Happy with his original investment decision, Jim did not make any additional contributions. Dan, the wiser brother, understood the effects of compounding and made additional regular savings of $100 per month. Tom – the wisest of them all – worked out he could afford to save an extra $200 per month and made sure he always contributed that amount to his investment. The difference in their investment returns over 10 years is startling: 

Of course the example is a stylised one. It ignores potential fluctuations in investment returns over the period, which would affect the three outcomes in reality.
These examples highlight how compounding and contributing regularly to an investment can have a major influence on investment performance. The long-term performance impact of compounding can be significant and must not be overlooked by investors. Perhaps Einstein and Rockefeller were right, after all.

Speak to your financial adviser if you have any questions about compounding. 

Source

Teaching Kids About Money - Tips From A Father and Financial Adviser

Teaching our odd about money is important and it is important to show our kids that money is not the point of life, but it allows us to live our lives on our own terms. So I'd like to articulate a few points about exactly what a kid needs to know about money. There are lots of things that kids need to know about money and finance, but I've managed to distill them down to a few key concepts that kids need to get used to. 

It starts with why this is a concern for parents. As a parent of three toddlers I have often been in that situation in shops that start with "Dad, can I have..." And you're left with what I call the parents conundrum... If I buy it, and I being a bad parent? If I don't am I also being a bad parent? What if I don't have the money to spare? Quite often I try in vain to turn the situation into a 'teachable moment' and try to implement some kind of reward/saving situation. In December it's quite easy to fall back o the old "maybe Santa will give it to you" thus instead of teaching our kids about money, we re-inforce the concept that if you're good the things you want will just appear...

As parents, what we want is to know that our kids will be smart with their money. We want to 'teach them how to fish' as the saying goes by inevitably we just keep handing out fish/

if we are going to raise financially savvy kids, here are the four things that I think they need to know. 

Money is finite

My son is 4 and knows how to spend money. It's quite easy, just take what you want to the counter, then swipe Daddy's magic card... If this idea isn't squashed at the age of 4, it will continue into adulthood. Kids need to know that money is finite, and I'll add that they need to know that it arrived due to effort. We teach our kids to count, so why aren't we doing this with money and killing two birds with one stone? If you have $20 and the thing you want is $30, then how many times do you need to mow the lawn to buy the toy?

Be patient

There is this concept that I've been told about, called delaying gratification... not something that I'm proficient in, but quite often the best value can be found by waiting for the right time to buy something. Take a mobile phone for example, saving to buy one for $1000 is much better than borrowing to buy one for $1200 just because you want it now, but a lot of kids will take the quick option. There are plenty of studies that show kids who can delay gratification are generally more successful in their lives, which is what we really want as parents isn't it?

You need to set goals

Kids have a natural tendency to just ask for what they want, and react according to your response. If they want something that you are not able or inclined to buy for them right now, then it become something that they need to achieve if they really want it. Helping them set a goal and understand what is required to get there is an important process to go through. 

Your goals need to prioritised

The concept of competing goals is important to developing smart money behaviour. Have you ever seen a kid enthusiastically compose their Santa list? They usually write down every single thing they've every seen in the last 12 months with furious vigour. In our house, the only fat man that gives out presents is me, and I have finite resources. So teaching your kids that as in adult life, they want one thing bad enough, they may have to wait for forego some other goals. If you have $100 and three $50 goals then you really need to learn how to prioritise your goals, which is hard to instil in our kids but useless we do, our kids won't learn this skill. 

If you can find a way to instil these four behaviours in your kids from an early age, they they stand a much better chance of growing up to be financially savvy which is what we all want for our kids.

Written by: Ash McAuliffe  

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