KEY PRINCIPLE FOUR: The power of compounding
Once you have a budget and a little extra money to put away each week, you then need to work out what to do with that money. I want to explain something that when understood, will change your financial growth more than anything else.
Most people know, that if you put your money in a bank or invest it in shares, the money you deposit, earns interest, or dividends. In many cases, people invest money and when they earn interest, they simply take the interest out and spend it.
An important thing to note, is that while it is tempting to do this (take the money and run), if you leave the interest in the bank, or reinvest the dividends back into your shares, then compounding will grow your investment, much faster than if you took the windfall. Put simply, compounding is where the interest you earn, or the dividend you receive, is added to your initial deposit and then becomes the new amount on which the interest, or dividend is calculated.
So, instead of you earning interest on just the deposited amount, you earn interest on the deposited amount, plus the interest that you earned from the previous period. As long as you don’t touch the interest earned, this continues to grow. At first, it will seem to be growing very slowly, but as momentum builds and compounding takes full effect, your savings will suddenly explode of the chart.
As the above illustration shows, at first, you don’t notice the effects of compounding, but the longer time goes, the greater the benefit of compounding.
I was looking at my budget, that we discussed in Key Principle 3, when I was curious as to what the outcome would be, if I was to not spend $100 per week and instead save it, or invested it. The moment I did this exercise, is when I got the “ah-ha, this is what is possible by not buying that coffee” moment. It took me about half an hour to calculate, but I must say, it was the best thirty minutes that I have spent, because it changed my mindset completely.
Let’s take that $100, that I found by cutting back on lunches and coffees and see how the power of compounding works. Annually, $100 per week, equates to $5,200. Let’s say that we invest that amount over twenty years, earning interest at a rate of 10% annually.
- Please note, that in order to gain 10% return, you will need to have a balanced portfolio of shares, as well as cash in the bank. I will discuss how to do this, in Key Principles 5 & 6.
In this first case, we don’t keep adding more money to our investment. We just save $5,200 and don’t touch it for twenty years.
If we earnt 10% on $5,200, that would give us $520 in interest per year. The incredible thing about compounding, is that it compounds on the interest, as well as the original $5,200.
For example, in the first year, we earn $520 interest. Add that to the $5,200 that we started with and now we have $5,720. Now we are earning interest on the entire $5,720 and not just the $5200. As I mentioned a moment ago, you can’t spend the interest earnt. You must leave it, because this is where the power of compounding occurs.
If you were to invest that $5,200 over twenty years and not touch it, with the power of compounding, it would be worth $34,983 in twenty years’ time. Not bad for a few small sacrifices for just one year.
This next part, is where I got excited. Let’s say that you were going to continue saving $100 per week and invest that additional amount, each year, over ten years. With the power of compounding, the results are incredible. Below is a table illustrating how your $100 per week, will grow over ten years using the power of compounding.
As you can see, your $100 per week, which would otherwise only be $52,000, has now grown to $91,162 in ten short years, through the power of compounding. That’s $39,162 in interest that you have earnt over that time.
Here’s where it gets even better. In the next three lots of five years, your money almost doubles every five years.
By year 15, your $100 per week, would be worth – $181,738
By year 20, your $100 per week, would be worth – $327,612
By year 25, your $100 per week, would be worth – $562,545
Not only, do you now have more than half a million dollars, but on top of that, by year 25, you are earning $51,140 per year; in interest alone. In other words, you could take out that much each year and not be eating into your capital. If you are around my age (44) and planning on retiring in around twenty-five years, then $51,140 per year, will be a nice start.
Doing this exercise, made me realise, that just by making a few simple changes to my life, like cutting out one coffee a day and making my lunch, can make a massive difference to my wealth in years to come.
Don’t you think it’s worthwhile?
In the next principle, – PRINCIPLE FOUR – “Invest the difference,” we look at how to achieve these results.
For more information on this principle and how to “Create The Life You Want,” check out my new book here.
