Snowballs and investors — and the magic of compound interest
“COMPOUND interest is the eighth wonder of the world. He who understands it, earns it... He who doesn’t, pays it.” This quote is dubiously credited to Albert Einstein, but the power of compounding is beyond doubt and often underestimated by investors.
To illustrate the power of compounding, let us look at a simple example.
Let’s say a woman starts to save for retirement at the age of 25 and puts €2,000 into her pension each year for the next 10 years, a total contribution of €20,000. Thereafter, she does not contribute anything further to her pension but she manages to generate an investment return of 8pc each year and continues to do so until she retires at the age of 65. (Over the past 100 years, returns from global stock markets have averaged between 8pc and 9pc per year, including dividend income, which is why I use the 8pc figure here).
A man, however, starts his investment plan later in life, at the age of 35, just when the woman has finished contributing to her plan. The man contributes €2,000 into his pension every year until he is aged 65, a total contribution of €62,000 over 31 years. He also gets the same return of 8pc a year.
Given the data, who would you think has the larger lump sum when they retire at 65? Surprisingly, even though the man has contributed three times as much as the woman, it is the woman who walks away with the bigger lump-sum of €291,000 versus the man’s €266,000. This simple illustration shows the power of compounding: The woman has made 14.6 times her original investment of €20,000 whereas the man has only made 4.3 times his original investment of €62,000.
No wonder Warren Buffett, the iconic chairman of Berkshire Hathaway, called his biography Snowball. Build a small snowball and send it downhill and watch it grow on nothing more than its own weight.
When developing a pension or savings plan, there are many things to consider but, if followed, three rules of thumb can help enhance returns and provide you with financial security in retirement.
First: Start young — as just illustrated, the earlier you start, the more time you have for compounding to work its magic.
Second: Make regular contributions. Investing regularly removes the risks associated with trying to time the market, which often ends with investors buying at high points in the investment cycle and selling in a panic at the bottom. The regular contributions should be invested in a disciplined manner throughout good times and bad. Diversification is also important and can be achieved using various passive and actively managed funds.
Third: Invest in equities. Equity markets have delivered the best returns of all the asset classes over the last 100 years of recorded data. At this point in the cycle, with equity markets valued at more expensive levels relative to history, equity returns are likely to be lower than the historical average. However, if you continue to invest your pension contributions on a regular basis, some will be invested when markets are at lower levels and this will enhance the returns. For anyone with more than 10 years to go before they retire, a full allocation to equities makes sense at this point in the cycle, given the alternatives.