Having been exposed to accounting and finance for most of my life, I almost take for granted that every knowledge worker understands the power of compound interest. However, I have had a number of interactions in the past year where the importance of this topic has been highlighted to me, along with the realisation that most of us are not using it to our best advantage.
The most recent instance was when I was helping a friend with a retirement model. The most prevalent assumptions in a retirement model are (1) investment return, (2) inflation, and (3) longevity (assuming the income you require is an absolute). While there’s very little we can do in terms of predicting longevity, an awareness of the parameters of investment return and inflation is helpful. The focus of this article is not on inflation. At a high level, however, inflation is affected by the aggregate demand for goods and services in the economy as well as by the economy’s productive capacity and increases in production inputs. This thought article will focus on investment return.
Albert Einstein was famously quoted as saying: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”. Therefore, to tap into this wonder, make sure you understand it, but more than that (if I’m allowed to add to Einstein’s quote), actively use it!
As investment return is inversely correlated to risk, you need to have a stance on your risk tolerance levels, as a starting point. But to emphasise the differential power: keeping all other constants as is in the retirement model I was working on, changing the investment return by 3%, added 20 years to my friend’s savings, that is his retirement money would last 20 years longer. That is the difference between having enough savings to make it to 95 years (30 years post retirement) rather than 75 years (10 years post retirement). And this model was only starting at retirement age. Can you imagine how many more years you could add by earning a higher differential return on your savings while you are still working?
If you cannot get to grips with the added risk, direct your eyes to any fees you might be paying. While 3% in fees might not sound like a lot, I have just illustrated how it could equate to an extra 20 years of retirement wealth. An incremental increase of 0,5% in fees per annum could take away years of savings in retirement.
So while you may not be able to replicate the Hanging Gardens of Babylon in your backyard, you can replicate another wonder. It may not be as spectacular as the pyramids, but it is definitely more powerful. It can bring you financial security and allow you to enjoy those final years of your life worry-free. Work the wonder and earn as much compound interest as possible!
Let’s look at some helpful guidelines or considerations when investing.
1. What should your stance on risk be?
There are risk attitudes that prevail in every human being – risk averse, risk seeker and risk neutral.
People are risk averse when they shy away from risks and prefer to have as much security and certainty as is reasonably affordable in order to lower their discomfort level. They would be willing to pay extra to have the security of knowing that unpleasant risks would be removed from their lives. Finance professionals consider most people to be risk averse.
A risk seeker, on the other hand, is someone who will enter into an endeavour as long as a positive long-run return on the money is possible, however unlikely.
Finally, an individual may be risk neutral when his or her risk preference lies in between these two extremes. Risk neutral individuals will not pay extra to have the risk transferred to someone else, nor will they pay to engage in a risky endeavour.
The best stance on risk is not a simple one, however financial theorists and researchers agree that investors who are successful over the long term tend to work within the risk limits and thus being risk neutral is seen to be the best approach over the long term to ensure that you do not go broke but still capitalise on positive returns.
2. The importance of paying attention to fees.
I mentioned earlier that an incremental increase of 0,5% in fees per annum could take away years of savings in retirement. So what can you do to lower your fees on your retirement savings?
Here are some suggestions:
- Pay close attention to the fees your retirement plans are charging. Read the fine print, and know exactly what it costs you to have your money in any plan you participate in.
- Consolidate your retirement accounts. If you have ten different retirement accounts, each charging R500 per year in annual fees, you'll be paying R5 000 per year for the privilege of having so many accounts. Cut your accounts down to two or three, or even one account, if you can.
- Move money from employer plans to individual retirement plans as soon as possible. Not only are employer-sponsored plans more fee-intensive than self-directed retirement plans, but the fees are often buried deeper in the plan so that you're not entirely aware of them.
3. All this hype about compound interest, but how does it actually work?
Compound interest is interest paid on the initial principal, as well as on the accumulated interest on money you have invested. Compound interest is like double chocolate topping for your savings. You earn interest on the money you deposit, and on the interest you have already earned – so you earn interest on interest.
Here is an example: If you have invested R10 000 for 5 years at 6%, with interest calculated and added monthly, you would earn R3 489 in compound interest after 5 years, giving you a total of R13 489. Returns are higher because you're earning interest on interest.
One thing that you should be picking up from this example is that the longer the time horizon, the greater the returns. While people closer to retirement age may not have the time to benefit hugely from compounding, it can be a significant help for younger investors looking for the quickest way to build a nest egg.
A final thought …
While the classic Wonders of the Ancient World have been replaced by the new Seven Wonders, the eighth wonder has remained constant throughout: compounding. Its cumulative effect on financial wealth is astounding. Moreover, it is not situated in some faraway place you need to travel to. It is in every investment and loan you own – growing cumulatively on a daily basis. But, is it working for you, or against you? Be sure to truly understand the workings of this wonder, and use it to your own benefit.
Elton Pullen is a CA(SA) and senior lecturer in the Accounting Department at the University of the Western Cape. He has been selected as one of only 35 Top CAs under the age of 35 in the South African Institute of Chartered Accountants (SAICA) competition for 2017. He is an external facilitator at USB-ED.