How Compound Interest Can Grow Your Funds
Investors have been putting more money in their wallets through the power of compound growth. Most people are familiar with the concept of simple interest. However, even in a financially savvy country like the UK, a survey found nearly 50% of the respondents did not know the meaning of compound interest – when interest is earned on interest which has already been accrued.
Think long-term goals like retirement, or your child’s education fund. With a longer time horizon, you can turn to the most powerful investing tool of all: compound interest.
The snowball effect
Think of compound interest like a snowball rolling from the top of a hill.
When you first started investing, your capital (the money you start your investment with) may be the size of a football, but over time, as it rolls down the hill, it accumulates more snow (interest) and soon becomes the size of a beach ball!
The beauty of compound interest is, as the snowball gets bigger, the area onto which new snow can stick gets larger – earning you even more interest.
For example, if you invest RM1,000, with a 10% average interest per annum, here’s how much you get in return:
In the first year, you are only earning RM100, but by the second year, you have accumulated a return of RM210, and by the third year, RM331*! The longer you let your money compound, the higher your return will be.
*The returns are cumulative.
Why compound interest matters
To highlight the magic of compound interest, and how you can take full advantage of it in your investment, imagine these two scenarios:
With the help of compound interest, you can gain greater return of investment even with lower total investment amount, if you invest earlier.
This is especially helpful for people saving their money through an investment vehicle over a long period, such as saving for retirement.
Why depend on compound interest
For the savvier investors who can anticipate the market movement and predict the volatility of shares market accurately (or as accurately as possible), then the returns will always be greater through timely shift of money from one asset class to another.
Unfortunately, most people can’t, or at least not consistently. Investors will end up buying expensive and sell cheap, at least a few times in their investment, cutting their returns.
Furthermore, every shift causes transaction and trading costs. All these costs reduce your returns. Sometimes, it pays to let your money stay put and just enjoy the compounding effect of your interest!
Knowing compound interest doesn’t just tell you to save, but it also tells you the manner you should save to take the best advantage of the snowballing effect. Earning 6% on average a year may seem like peanuts now, but over multiple years and even decades, you can easily grow your funds by more than 50%, not to mention successfully combat against the rising inflation.
Even though putting your money in an investment vehicle will see its value lurch up and down, but at the end of the day, you still win, compared to the cash you save in a bank account.