Compounding interest : The 8th wonder of the world?

Let’s take a look at this scenario: Alan’s parents gave him RM25,000 on his 20th birthday. Alan proceeded to invest the lump sum into an Equity Fund Unit Trust. He did not bother about the funds until he turned 60.

Meanwhile, Betty, aged 50, found out to her horror the actual amount she would require for her eventual retirement. She saved aggressively, investing RM60,000 a year (equivalent to RM5,000 a month) until she turns 60.

Fast-forward to the time when both of them finally turn 60, who do you think has managed to accumulate more in their investment account?

To put things into perspective, Alan’s cost of investment was RM25,000. On the other hand, Betty has invested RM600,000 over 10 years. As it turns out, Alan’s account has burgeoned to RM1,131,481.39 compared to Betty’s RM1,051,870.

Why couldn’t Betty catch up to Alan’s investment even though she ramped up her savings in her later working years? This is due to a concept known as compounding interest.

Well, according to Prof. Albert Einstein, compounding interest is the eighth wonder of the world. With more time in the market, and harnessing the full effects of compounding, Alan has managed to maximise the earnings potential on his investment.

The snowball effect – how does it work?

Analysing Alan’s investment, we can see here how the compounding process works. (See table below)

Starting with an initial value of RM25,000.00, the amount grew by 10% a year to end at RM27,500. In Year 2 (Alan aged 21), interest is now calculated on the accumulated balance at the end of Year 1.

Alan’s investment increases in value by ever-greater amounts each year due to the interest earned, which subsequently accrues more interest.