Albert Einstein was famously awestruck by the concept of compound interest. He referred to it as both the greatest mathematical invention of all time and the eighth wonder of the world. And we are assuming it would take a lot to impress Mr Einstein.
Compounding can be defined as the process of generating more return on an asset’s reinvested earnings.
When you invest money you can expect to receive interest on your capital. The next year you will earn interest on both your original capital and the interest from the first year. In the third year you earn interest on your capital and the first two years’ interest. Simply put, compounding helps your investments grow exponentially over time, and requires determination and dedication.
We all know the importance of saving: putting money aside for a rainy day, planning for retirement, building up a deposit on a house. What many do not realize is the magic effect compounding can contribute to the equation.
Let’s take an example
If you were to invest 500€ every month during your entire working career, and assuming a fixed return of 4% per annum, you will have accumulated a total of 590.981 € by retirement (40 years). A very nice nest egg to compensate the dwindling and inadequate state pension you will be entitled to. Your total deposits over the period account for 240,000 €. The compound effect equates for the rest: a staggering 350.981 €, or 60% of your accumulated capital !
(Source: http://www.helpfulcalculators.com/compound-interest-calculator)
However, if you delay saving until you have been working for 10 years, the accumulated capital will only be 347.025 € after 30 years. To reach the same target amount as the first example, you would need to save over 850 € per month. That is 70% harder!
What does this tell us?
It is crucial to start saving as early as possible. This requires discipline and regularity.
Adopt a monthly savings plan and commit to it, however tempted you may be to divert the funds to a holiday or new gadget. We know logically that we need to save more for retirement, but we often struggle to sacrifice present consumption.
Bear in mind that no one can accurately predict interest rates or what might happen in the stock market. But what you can do is control when you start and how much you save.
Don’t stress your future self with crushing amounts of retirement savings up till the very end of your career. Your bank balance and peace of mind will thank you for it.