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The Weekly Advertiser Horsham - - News -

When you in­vest over a pe­riod of time, com­pound in­ter­est is your best friend. In ef­fect, it means you are earn­ing in­ter­est not just on your own cap­i­tal, but also on the in­ter­est you’ve al­ready earned. Over the long term, this might be phrased as ‘in­ter­est on in­ter­est on in­ter­est on in­ter­est on in­ter­est …’ or more sim­ply, ‘free money’!

So how do you get this free money? This how…

A sim­ple start

Imag­ine you place \$100 in an in­vest­ment that earns 10 per­cent. At the end of one year, you’ve earned \$10.

Then you spend all the in­ter­est you re­ceive. At the end of each year, your in­vest­ment amount is back to \$100. That’s sim­ple in­ter­est. At the end of 10 years, you will still have your \$100, and you will have re­ceived a to­tal of \$100 in in­ter­est.

I = P(1+r)n-p

Don’t worry, we’ll do the maths for you. It cal­cu­lates your net profit when you earn in­ter­est on the in­ter­est. That’s what com­pound­ing is all about.

Go­ing back to our first ex­am­ple – if you re-in­vest the in­ter­est on your orig­i­nal \$100, at the end of the first year you will have \$110. Leav­ing it in­vested at 10 per­cent, you will earn in­ter­est of \$11 in the se­cond year, bring­ing the to­tal in the ac­count to \$121. If you keep go­ing for 10 years, your in­vest­ment will grow to \$270.70 – that’s your orig­i­nal \$100 plus \$170.70 in in­ter­est.

Time is money – lit­er­ally

is

This ex­am­ple might not seem so im­pres­sive, but the power of com­pound in­ter­est re­ally shines over the long term.

Look­ing at our sim­ple sit­u­a­tion and tak­ing the in­ter­est out each year for 30 years, you will earn a to­tal of \$300 in in­ter­est. But re­ly­ing only on the com­pound­ing of the in­ter­est – for ex­am­ple, no other de­posits are made – the to­tal in­ter­est earned over the same time would be \$1883.74.

A child born to­day could eas­ily live to 100. Sim­ple in­ter­est on a \$100 in­vest­ment would amount to \$1000 over their life­time. Left to com­pound un­touched at 10 per­cent, that same in­vest­ment would grow to \$2,113,241. Even on such a small ini­tial in­vest­ment, that’s an in­cred­i­ble dif­fer­ence.

The other crit­i­cal fac­tor is the ac­tual rate of earn­ings. If the earn­ings rate dropped just one per­cent to nine per­cent a year, a 100-year in­vest­ment would grow to only \$783,548.

A cou­ple of drags

Don’t for­get to take into ac­count tax and in­fla­tion. They act as drags on in­vest­ment per­for­mance.

Let’s as­sume in­vest­ment earn­ings re­main at 10 per­cent and are fully tax­able. What will your \$100 grow to over 30 years at dif­fer­ent tax rates?

As for in­fla­tion, al­though we are cur­rently ex­pe­ri­enc­ing very low in­fla­tion, no­body knows how long this will last. If it reaches the Re­serve Bank’s tar­get of three per­cent a year, you will need \$2.43 in 30 years’ time to buy some­thing that costs \$1.00 to­day.

There are many ways of min­imis­ing the ef­fects of tax and in­fla­tion. Pick­ing the right tax en­vi­ron­ment is clearly im­por­tant. Cap­i­tal gains are only taxed when an in­vest­ment is sold, so growth as­sets have an ad­van­tage over those that only pro­duce in­come. They also cope bet­ter with in­fla­tion.

In­vest­ment risk

Al­ways re­mem­ber, seek­ing higher re­turns gen­er­ally in­volves tak­ing higher risks but some of those risks can be man­aged with an ef­fec­tive and pro­fes­sion­ally con­structed in­vest­ment strat­egy.

If you want to take ad­van­tage of ‘the most pow­er­ful force in the uni­verse’, talk to a li­censed fi­nan­cial ad­viser.