Understanding compound interest will go a long way to building wealth over time. It has been said that ‘compound interest is the eighth wonder of the world; he who understands it, earns it. He who doesn’t, pays it’.
Unleashing the power of compound interest is fundamental to building and maintaining wealth over the long-term. Getting to grips with its impact on our investments, debt and credit is, however, a little more complex. With that in mind, we will be looking at compound interest in more depth over the coming weeks in order to help you better understand the principle, the pros and cons, and how exactly it affects you and your personal finance.
In this article we start right from the beginning, with a familiar parable that might help…
The Emperor of China was so excited about the game of chess that he offered the game’s inventor one wish. The astute inventor replied that he wanted one grain of rice on the first square of the chessboard, two grains on the second, four on the third, and so on all the way through to the 64th black and white square. The unwitting Emperor immediately agreed to his seemingly modest request. The Emperor, however, did not understand compound interest.
By the 30th square alone, the Emperor’s debt had amounted to over a billion grains of rice. By the time he reached the 64th square on the chessboard, the sum owed to the cunning inventor had reached over 18 trillion grains of rice! The Emperor had bankrupted his kingdom with one simple request.
What this example captures so brilliantly is exactly how quickly, when compounded, our investments can grow. The calculation behind this example is relatively simple, and it is the same principle which calculates the growth of your investments over time. Essentially, for every new square on the chessboard we double the amount of rice owed. You can use exponents to quickly work out the exact amount at any one square, for example, 230 = 1 073 741 824.
So, how exactly does this relate to investing?
For the majority of our clients at Southern Charter we target a return of inflation plus 5% to 7%. Essentially, this amounts to you doubling your money approximately every five years. The more five year periods that your money remains invested with Southern Charter, the wealthier you will become.
To illustrate this principle in Rand terms, let’s say you invest R100 000 for 35 years (the average person’s working lifetime).
- After 5 years your investment will double and be worth R200 000.
- After 10 years your investment will be worth R400 000.
- Now it really starts to get exciting…
- After 20 years your investment of R100 000 will be worth, approximately, R1 600 000.
- And finally after 35 years your investment should be worth a total of R12 800 000.
Although these are far from exact figures, the principle remains the same.This is why investing for the long-term is so essential to wealth creation and growth. Some important things to always remember when it comes to investing are:
- Start early to maximise the lifetime of your investment
- Continue to add to your investment in order to see the number grow even more substantially and rapidly.
- Preserve your money! Don't withdraw it unless you absolutely have to, otherwise you'll have to start again from scratch.
If you follow these steps you will truly be on the way to financial liberation!