Question:
I recently read an article about saving and it mentioned the benefits of compound interest.

What exactly is compound interest and how does it work?

Answer:
"The most powerful force in the universe is compound interest."

These words may conjure up thoughts of a slick investment professional attempting to entice your precious wealth into his management. The truth, however, is these words were in fact spoken by the eccentrically likeable genius Albert Einstein. While the other Seven Wonders of the World stand the risk of being replaced by newer, more impressive structures and landmarks, this wonder holds on confidently to its rightful place and the principles remain as relevant today as it did when retail investing was still in its infancy.

Essentially, compounding interest refers to the cumulative effect of interest (or growth) being accrued on interest already earned with the long-term effect being exponential.

Perhaps the best way of illustrating this is by means of an example:

The tale of two twins

One of them (let?s call her Amy) contributed R1000 each month to an investment for a period of 10 years while her brother (Allan) contributes R1000 every month for 30 years. By the time they both retire, Amy finds herself with a final investment value of just over R2.8-million versus Allan?s R2.2-million. One might argue that Amy must have had incredible insight and investment prowess to have achieved this. Now although this may be true, it does not come in the form you might imagine. What if you were told that both Amy and Allan enjoyed the exact same investment return of 10 percent?

Confused? Don?t be! All Amy did was harness the incredible power of compounding interest by investing earlier than her brother Allan.

Where Amie started at age 25 and stopped 10 years later at 35, Allan chose to wait until he was 35 to begin and had to contribute for the remaining 30 years of his active employment bringing them both to age 65 where Amie?s value was approximately 25 percent more than Allan?s despite Allan contributing triple the amount in 'premiums'. After the initial 10 years, Amie?s fund value was a touch over R200 000 and with a return of 10 percent it is not difficult to calculate that the interest she earned was already in excess of Allan?s premiums. In short, her money had started working for her while Allan was still working hard for his.

This scenario often highlights the cost of delaying one?s saving and therefore supports the adage that the best time to start saving is yesterday.

Another way of highlighting this is by using a simple calculation known as the rule of 72. What this offers is a way of calculating how long it will take for your investments to double in value merely by dividing the number 72 by the assumed growth rate. Given the example above and using the growth rate of 10 percent one could easily deduce that one?s investment doubles in value every 7.2 years (72?10). Compared to 'simple' interest, which would have taken 10 years (10 years of adding 10 percent per annum = 100 percent). In effect, compounding interest has accounted for almost three years of simple interest savings.

The rule of 72 also has an inverse use in that it can calculate how quickly inflation erodes your buying power. The most recent CPI figure suggests an inflation rate of eight percent, meaning that if you put your money under the proverbial mattress and do not enjoy any growth on that money, your purchasing power will half every nine years (72?8 = 9).

This highlights the risk of your investments not keeping pace with inflation and that taking on some risk in exchange for inflation-beating returns could be the safest investment decision you could make. History has shown us that having all your money in cash will often deliver inflation lagging returns for individuals on higher tax brackets and in effect are 'saving themselves poor' by guaranteeing long-term losses in real terms.

acsis Limited is an authorised financial services provider. The response to the question covers some of the issues in a general and factual manner and does not constitute advice. It is important to consult with a financial planner who, after an analysis of the individuals? personal needs, goals and circumstances, will be able to provide comprehensive and appropriate advice.