The power of compounding

Imagine planting a tree. At first, it’s just a seed, but with time, water, and sunlight, it grows taller, spreading its branches wide. Now, picture your money as that seed, growing and expanding year after year — that’s the magic of compounding.

What is compounding?

Compound interest is when the interest you earn on your investment gets reinvested, earning you more interest. So, you’re not just earning interest on your original money (principal amount), but even the interest earns interest. There’s a quote from Benjamin Franklin that goes, “Money makes money. And the money that money makes, makes more money.”-He was clearly describing compounding.

No matter where you are in your financial journey, understanding the power of compounding is important. It can help you earn better returns on your investments and plan for major life milestones. It’s important to note that investments aren’t guaranteed and there’s a chance of getting back less than you put in. However, assuming your investments grow over time and keep up with inflation, compounding can work wonders.

How does compounding work?

Assume you invest R20 000 at an annual return of 8%. In the first year, your investment would grow by R1 600, giving you a total of R21 600. Instead of taking out that R1 600 profit, you reinvest it. In the second year, your investment grows by 8% of R21 600, which is R1 728, bringing the total to an amount of R23 328.

Depending on how long you invest, this process continues year after year, with growth not just on the original R10 000, but on the increasing total. Over time, this can significantly boost your returns.

The key to realising the full potential of compounding is to stay invested for a long period of time, allowing your profits to multiply. The longer you stay invested, the bigger the compounding effect. Starting early and contributing regularly to your investments increases the rewards even further. Let’s consider Sarah and Mike, each of whom invests an amount of R100 000. Sarah reinvests her earnings every year, while Mike withdraws his profit annually. After a few years, Sarah’s investment would have grown much more than Mike’s, due to compounding. This can be seen in the table below.

Advantages of compound interest

1. Faster growth: By reinvesting your earnings, you’ll generate returns on both your initial investment and the returns generated, allowing your wealth to grow faster over time.
2. Wealth preservation: Compounding can help your investments to keep up with inflation, ensuring your wealth retains its value and purchasing power over time.
3. Easier goal achievement: Compounding makes it easier for you to reach your financial goals, and you might even end up with more than you need, creating a financial cushion.

Compound interest can also be your enemy

Just as interest on an investment compounds in your favour, interest on your loans, or debt, adds up over time, increasing the amount of time taken to pay off the loan. The main reason payments increase is because of compounding interest, meaning you keep paying interest on the original loan amount  along with the interest that gets added. If you only pay the minimum on a credit card, the debt can grow quickly and become overwhelming.

To  avoid this situation, it’s advisable to pay more than the minimum amount each month. For small loans, like credit cards, pay them off as quickly as you can.

For bigger debts, like mortgages or car loans, paying a bit more than the minimum can save you a lot in the long run and help you keep your finances in check. It’s all about not letting the interest accumulate, to your disadvantage.

Time is your best friend

Time is one of the most important factors to consider when it comes to compounding. The longer your money is invested, the bigger the potential compounding effect. That’s why starting early gives you a significant advantage. Let’s look at Sarah and Mike again. This time we consider what happens when they start investing at different ages. Assume they are both investing R1 000 monthly, compounded semi-annually, at an interest rate of 12%. Sarah starts at age 25, while Mike waits until he’s 35. Although they both invest the same amount, Sarah ends up with much more than Mike at age 65 – simply because she gave her money an extra 10 years to grow. This shows that starting earlier makes all the difference over a longer time horizon.

Source: Sanlam Investments Multi-Manager

Patience pays off

Whether you’re investing for your future or investing on behalf of your children, don’t worry if you’re starting with a small amount. Even small monthly contributions can grow into a large lump sum down the line.

Remember too, that investments don’t grow in a straight line. There will be good years and not-so-good years. But over the long run, compounding smooths out the market volatility so that your investment can show impressive growth.

Boost your wealth with compounding

• Start early and invest regularly: The earlier you start, the more time your money has to grow. Regular contributions (weekly, monthly or quarterly) add even more to your principal, boosting the compounding effect.
• Reinvest dividends and earnings: Whether your investment is in shares or unit trusts, reinvest any dividends or capital gains to maximise growth.
• Choose growth investments: Consider investments with a high growth potential, such as equities. High-growth investments increase the power of compounding.

Compounding is a quiet but unstoppable force. It’s one of the easiest ways to grow your money. All you need is time, patience, and a little consistency. It boosts your investments, helping your money grow faster but it can also work against you in the case of loans, making your debt grow. The key is to make compounding work for you.