What’s the number-one investment hack? It’s simple: time.
Albert Einstein once described compound interest as ‘the eighth wonder of the world’. Essentially, it’s interest that you earn on interest — your money grows exponentially the longer you leave it invested.
Here’s an example to show how compound interest works…
The tale of Abe and Bella
Abe and Bella are both 25 years old and they’ve both just started working. They both plan to retire at 60 and both get advice to start saving towards retirement from day one. However, Bella decides that she would rather use the money she would have saved to live in a more upmarket apartment. Not Abe: he cuts back on his lifestyle costs and starts paying R2,000 per month towards his retirement.
Five years later, Bella reads a blog about the importance of saving for retirement and realises that she needs to start. She also saves R2,000 per month, in the same investment as Abe.
At this stage, Abe and Bella both have 30 years left before they retire. The difference is that Abe had a five-year head start. To understand the value of those extra five years, let’s look at two scenarios*…
Scenario A: Same number of contributions
Say Abe stops his R2,000 pm contribution five years before his retirement and Bella carries on to age 60. In this scenario, both would have made the exact same number of contributions overall, but Abe will end up with R6,7 million whereas Bella will only have R4,2 million — that’s R2,5m more for Abe! The extra money is purely due to the five years of compounding returns he had at the start.
Here’s a chart that shows the magic of compounding for Abe, demonstrating how significant those early contributions are.
Scenario B: Abe contributes less
The compounding effect is so powerful that Abe could stop contributing his R2,000pm at age 40, after 15 years, and he would still end up with more than Bella even if she carries on contributing for the full 30 years.
In this scenario, Abe would have about R5.4m at retirement, and Bella would have R4.2m. Abe is R1.2m better off, despite making half the contributions that Bella made.
This highlights once again how important time is when it comes to long-term savings.
How can Bella catch up?
In Scenario A, if Bella wanted to end up with the same investment value as Abe at age 60, she would have to save about R3 220 each month for 30 years — 60% more than the R2,000 that Abe contributes each month. He has to put away far less each month to reach the same long-term goal, simply because he started earlier.
Final word
It’s important to remember that in the scenarios above, neither Abe nor Bella withdrew any of their money. This would significantly reduce the impact of compounding returns. So, think twice before you dip into your retirement savings, especially when changing jobs…
Speak to a financial advisor or your HR department about your retirement investment options, then start saving now so that you can take maximum advantage of Einstein’s eighth wonder of the world.
* Scenario assumptions:
• Investment return of 10% per annum (effective), after fees.
• Investment returns are tax-free, given that a retirement annuity (RA) is used as the
investment vehicle.
• Cashflows occur at the start of each month.
• Total contributions per annum for Abe and Bella are within the SARS annual tax-
deductible limits.
• There are no withdrawals.
