Albert Einstein is credited as having said "compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it."
While there is some conjecture over whether Einstein really did make this statement, it's hard to deny that compound interest is indeed a very powerful, wealth building tool.
Here's a practical example which highlights the beauty of compounding your money.
Imagine you could save $6,000 per year – that's the equivalent of putting aside $500 every month.
From a standing start (let's assume from age of 34) you begin setting aside $6,000 each year and investing it in the stock market.
For argument's sake, we'll figure you achieve a 10% return per annum (pa) on your investments – that's certainly no slouch for a return, but it's also not an impossible achievement either.
Consider this…
Listed investment companies (LIC) Australian Leaders Fund Limited (ASX: ALF) and WAM Capital Limited (ASX: WAM) have achieved total shareholder returns (TSR) of 11.9% per annum (pa) and 9.7% pa respectively over the past 10 years.
Meanwhile, Magellan Financial Group Ltd's (ASX: MFG) flagship global fund has returned 10.8% pa since inception 9 years ago.
The maths is quite straight forward…
An investment plan committing $6,000 every year for 30 years at a rate of 10% pa will grow – thanks to the beauty of compounding – into $1,091,661 by the time you are 65.
Who wants to retire a millionaire?
There are a few key takeaways from this example.
Firstly, it takes time to build wealth. The earlier you start and the longer you allow your wealth to compound the better.
Secondly, compounding is a must! That means not touching the money you put in and reinvesting all the profits too. It's worth noting that under this example 'only' $186,000 of savings are contributed over those 30 years; the balance of $905,661 is all thanks to compounding.
Thirdly, returns matters and can make a big difference. Whilst 10% pa was used in this example, a review of the returns achieved by successful long-term investors such as Warren Buffett shows that even higher returns are possible. Taking the time to carefully construct a portfolio that will maximise your returns can make a huge difference to your wealth.
It would be naive to say that getting rich is easy. By utilising the above steps however, it certainly can be achievable.
