Albert Einstein, one of the most celebrated theoretical physicists in the modern world, is often credited with this quote ? ?Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn?t, pays it.?
While the veracity of the quote?s origin might be in question for some, the message of the quote is clear – compound interest is a force to be reckoned with. But, it
and sadly, there are some who?re just in too much of…
Albert Einstein, one of the most celebrated theoretical physicists in the modern world, is often credited with this quote – “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
While the veracity of the quote’s origin might be in question for some, the message of the quote is clear – compound interest is a force to be reckoned with. But, it takes time and sadly, there are some who’re just in too much of a hurry to let time work its magic.
For a starting sum of $1,000, most might be familiar with the big differences that can occur in the ending amount after a long stretch of time – say 20 years – if we vary the compound interest by just a small amount. As shown in the table below, a difference of 1 percentage point between compound interests can mean a difference of more than a 100% return in terms of the starting sum of $1,000.
|Compound Interest||Ending Amount for a starting sum of $1,000 after 20 years|
But, not many might have considered how big the difference can be between compounding at the same interest rate if we just stretch the holding period for a few more years. The second table, shown below, demonstrates how an investor could earn an additional 100% return on his capital if he merely stretched his holding period from 20 years to 22 years.
|Compound Interest||Ending Amount for a starting sum of $1,000 after 20 years||Ending Amount for a starting sum of $1,000 after 21 years||Ending Amount for a starting sum of $1,000 after 22 years|
The formula for compound interest is given as:
Ending Value = Starting Value x (1+Interest Rate)N,
\where N = number of years
While most people are concerned with improving the Interest Rate, the N in the formula can make a big difference to the Ending Value too. And that is why it is never too early to start. The earlier you start investing, the more time you have to allow N to work its wonders.
An investor who diligently invests $880 per month into the Straits Times Index (SGX: ^STI) 25 years ago would have turned his portfolio into a cool $1 million. But, if we stretch that investing period for 5 more years into the future, and assuming the STI grows at somewhere near its historical rate, the investor’s portfolio would have ballooned to $1.5m!
And, all that was achieved without the need for the investor to dance in and out of the market, which often leads to poorer returns. All the investor had to do was to stay in the game to allow compounding’s benefits to occur.
Of course, that’s just a theoretical example as index-investing tools for our local market would probably not have existed 25 years ago. But, investors now have easy access to low cost index trackers to invest in, such as the SPDR STI Exchange Traded Fund (SGX: ES3) and the Nikko AM Singapore STI ETF (SGX: G3B). These ETFs are able to track the STI’s movement very closely and give investors returns very similar to that of the index’s.
Foolish Bottom Line
If my friends were to ask me, ‘What’s a good rate of return to aim at in investing?’ I’ll turn the question around and ask them, ‘How long are you willing to be investing for?’
Yes, having a target to aim at for portfolio returns is important. But, stretching our investing and holding periods gives us an even better opportunity to maximise the benefits of the 8th Wonder of the World.
Not all of us can compound our wealth at high rates of return (because let’s face it, there are only that many Warren Buffetts around!) but even so, most of us do have time and it is an indispensable cog in the Compound-Magic-Machine.
If you can’t maximise the rate of return, then maximise your investing time-frame. Start as early as you can and stay the course – that’s the trick.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.