If you invested R10 000 in 1974 in the FTSE/JSE All Share Index (ALSI), your investment would have grown at a compound annual rate of 17.2 percent over 35 years; the same amount invested as cash would have grown at a compound rate of 13.1 percent. But the difference of 4.1 percent in annual compounded growth rates does not convey the scale of the difference in rand terms. Your ALSI investment would be worth R2.6-million, 3.5 times the value of your cash investment which would amount to R747 000.

This example illustrates the powerful effect of compounding interest (Click here to learn more about what Einstein called 'the most powerful force in the universe'), which in turn has three components:

1. Initial savings

2. The time for compounding to take effect

3. Real growth rates

Of course, in order to benefit from compounding, you first have to set some money aside for saving. However, South Africans are notoriously poor savers. One measure of this, the gross savings rates as a percentage of GDP, presents a mixed picture.

South Africa saved 15.4 percent of GDP in 2008, which compares poorly with India at about 30 percent, Brazil at around 25 percent and Australia at 22.5 percent. However, it is in line with the US at 13.1 percent, the UK at 15.6 percent and New Zealand at about 16 percent.

But gross savings includes corporate, government and household saving. If we look at households the picture is far worse.

South African households were saving, on average, about five percent of disposable income in 1992. However, this has steadily decreased and currently households are no longer saving but actually spending capital. This is in sharp contrast to an increase in household disposable income over the same period.

Give your money time to work for you

As the time allowed for compounding increases so the amount of growth, relative to the contributions, increases exponentially. The sooner you start saving, the longer you will have to benefit from what Albert Einstein referred to as the eighth wonder of the world, compound interest.

Wealth creation in terms of real growth rates

Obviously, the higher the returns, the more pronounced the compounding effect. That said, this is not the full picture, as the case illustrated in the first paragraph shows figures in nominal terms and does not take account of the effects of inflation.

The true picture of wealth creation should be considered bearing inflation in mind, to get the value in real terms. The inflation rate since 1974 has averaged 10.5 percent per year. Thus, an investment of R10 000 would have to be worth R333 125 today for it to have kept pace with inflation. Accounting for this, the ALSI investment created 5.5 times the amount of real wealth, compared to the cash investment.

Rob Formby is deputy director of retail operations at Allan Gray Limited

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