Investing 101: Compounding - Part 3

Albert Einstein called compound interest "the greatest mathematical discovery of all time". We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.

The wonder of compounding (sometimes called "compound interest") transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset's reinvested earnings. To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.

Let us make a hypothetical situation about two individuals; Kofi and Ama. They were both 24 years old, and have just completed university. Kofi is a very cautious person. He does not want to start investing until he is ready. When he graduates from university, he made plans. He would learn about investment for several years and then start putting money aside after he is comfortable with investing. Kofi is also a fairly hard-working person. He would keep saving from the moment he invests until the moment he retires at age 65. As it turns out, Kofi finally take the plunge in investing at age 30; 6 years after he graduated. He diligently put $1,200, is aside a year ($100 each month) out of his meagre salary to invest. He continues doing this for 35 years until he reaches 65. Through ups and downs, Kofi manage to make a 10% return compounded annually.

Let's now consider Ama. Ama like Kofi is also a cautious person. But she is knowledgeable as well. She knows that investing in risk-free treasury bills could yield her 10% annual compounding return if history is any guide. So, fresh off university, Ama started putting money aside for investing. She invests $1,200 a year ($100 each month) just like Kofi out of her meagre salary. However, after reaching the age of 32, she decides that she wants to enjoy life quite a bit. She stops contributing her $1,200 is but rather uses it to fund her annual old school reunion party at her home.

Which one do you think would come ahead? Kofi who pours his whole heart into investing for 35 years and never stop saving until he retires at 65 years? Or Ama who invests immediately after school for 8 years into treasury bills and stops contributing after she is 32 years old?

Ready for the answer?
Wow! Ama who saves for a mere 8 years, manages to beat Kofi who set money aside each year for 35 years. What is happening here? Compounding is clearly working its magic here. By starting early, Ama has a huge head start of 6 years and she let compounding do its magic later on.

You think you can start saving now?
The message is clear. Start now and save as much as you can early. Are you a lazy person? I am. So, start early and you only have to invest for 8 years to get to the same result as your friend who start 6 years later and saves for 35 years. The faster you start, the better it is. The higher the amount you save early on, the more money you will have when you retire.

When you invest, always keep in mind that compounding amplifies the growth of your working money. Just like investing maximizes your earning potential, compounding maximizes the earning potential of your investments - but remember, because time and reinvesting make compounding work, you must keep your hands off the principal and earned interest.