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By Rob Stark

Albert Einstein supposedly once said that compound interest is the most powerful force in the universe. In fact, he coined it the “eighth wonder of the world”.

The concept of compound growth may be difficult for many to comprehend but understand it we must! It should be the duty of every parent and education system to ensure their children and students have a thorough understanding of the compounding effect of money.

This is one concept where a 30% pass rate is unacceptable. If we follow a disciplined plan in implementing it in our lives, future scarcity of money would not be an issue.

Interest on Interest

The basic concept of compounding revolves around earning interest on interest: the longer you invest for, the more interest you earn. Hence, growth exponentially increases as interest is earned on interest that has previously been earned. A great way to think of it is like a snowball rolling down a hill; where something very small grows and grows as it develops momentum.

This is best explained with a basic illustration.

If you invest a once-off single amount of R1,000 in a product delivering an annual return of 10% then the effect on your investment will look like this:

After 1 year, your R1,000 increases to R1,100. It thereafter increases to R1,210 and R1,331 etc. After 8 years, one has more than doubled one’s money – by sitting back and merely having the discipline… to do nothing! This is compounding at work…

Let’s increase the figures

Invest R30,000 at the start of each year for 30 years in an investment delivering a return of 10% per annum:

Note how in your first year you earn a return of R3,000 whilst in your 30th year your returns are R493,482!

Warning! It works both ways…

Whilst compound interest clearly does assist with growing wealth, you must bear in mind that the effects can also work against you when it comes to debt. This “most powerful force in the universe” can very quickly become your worst nightmare if you become a borrower: think “my mortgage bond!” Why you may ask? Because instead of earning interest on interest as an investor, you are conversely charged interest on interest as a borrower!

Patience is a Virtue

Hence, it’s clear that for compounding to work in your favour, you are required to have great patience with your investments. If you’re in too much of a hurry to spend your hard-earned income, then it can’t do its work. You need to leave it and let it do its thing. This is much like the investment markets, where fund managers often employ strategies over seven or eight years or longer. In this way, they aim for the best investment returns under constantly changing market conditions and economic cycles.

The value of compounding is not felt over the short term; it is experienced over periods approaching 15, 20 and 30 years. Again, much like the investment markets.

A little bit more

What also hugely increases the value of one’s outcome is the addition of extra capital. By injecting cash amounts on a regular basis, the entire compounding effect snowballs with additional momentum.  And, as we’ve just seen, the bigger the sums, the greater the effect. Such is the unique value of compounding.

All this requires is the discipline to invest, and then remain extremely patient. You need to sit back and literally watch your money grow.

The results of following this disciplined approach are compelling, and a happier and more financially abundant future lies ahead for all those who allow the fruits of their labour to flourish.

If we can teach our children, friends and families this lesson, and maintain the discipline to stay invested over the long term, the result will be well worth the “effort”.