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Compound interest rewards patience in an impatient world

Compound interest - its impact is truly miraculous. For more than 30 years I have been writing and speaking about its power, but do you understand it?

It is slow to start: nothing much happens in the early years. But that’s life – anything worthwhile takes time. This applies to getting fit, losing weight, becoming good at your sport, or building a business.

Accept that success takes time

In his book Atomic Habits, James Clear talks about “the plateau of latent potential”.  He likens the plateau to a species of bamboo, which spends its first five years building extensive root systems underground, before shooting 90 feet into the air over six weeks. Just because it sometimes takes longer than we’d like to see the results of our efforts, doesn’t mean that our efforts are going to waste.

In fact, most of the important work — the build-up — won’t seem like it’s amounting to anything, but of course it is.

Any goal we have will take time and effort to accomplish and beginning it will most likely be harder than finishing. But we have to keep going, because habits and hard work compound.

Epictetus tells the story of Lampis the ship owner, who, on being asked how he acquired his great wealth, replied, “My great wealth was acquired with no difficulty, but my small wealth, my first gains, with much labour”.  Yet the average human being is wired for fast results. This is why many of those who start an investment programme (or fitness programme, dietary change, sport, or business) give up in the early stages. They are discouraged by what they see as lack of progress.

Just be patient and consistent

So, in compounding, you have to wait to see results. Your small, consistent efforts will, if you are patient and consistent, reap great rewards. But the other most important factor that determines how fast your money will grow is the rate of return you achieve. The combination of time and a good rate of return turns small sums into a small fortune.

Over Christmas I was thrilled to receive an email from a woman I first met as a client in 1991 — 30 years ago. Beryl is now 88, and the $20,000 I invested for her in January 1991 into the Advance Imputation Fund is now worth just over $700,000. The fund was run by legendary investor Robert Maple-Brown until his death in 2012.

The numbers are fascinating. If we go to the Stock Exchange Calculator on my website, we find that $20,000 invested in the Ordinaries Accumulation Index in January 1991 would now be worth $337,000. That’s a return of 10.23% per annum, which is great by anybody’s standard. However, Beryl’s fund clearly beat the index. If we run the numbers using my Compound Interest Calculator, we discover that a return of 12.6% per annum would grow $20,000 into $700,000 in 30 years. That 2.37% difference in rate of return almost doubled Beryl’s money over the 30 years.

Why have I compared her returns to the All Ordinaries Index? Because the index is available to every investor, irrespective of their financial knowledge, and there is no requirement to pick winners. Some 20% of actively-managed funds do outperform the index long-term. The Catch-22 is that 80% do not beat the index after fees have been taken into account.

So, the problem for investors is finding the outperforming funds. The obvious solution is to consult a good adviser to get advice on funds which suit both your goals and your risk profile. Good advice costs up front, but in the long run it doesn’t cost – it pays.

But there is more to financial success than just picking a good selection of managed funds. Beryl’s husband is now 94, and they have a large amount of money coming out of a maturing interest-bearing account in a month or so. She was also seeking input from me about to what to do with the maturing money.

Financial planning options

After a long discussion, I pointed out that out that at their stage of life, ease of management is critical. Given their investments are already well diversified for their ages, and they have no chance of getting the age pension, they could simply leave the share trust to keep compounding and draw down on the money in the bank. Hopefully, the share trust will grow faster than their money in the bank would reduce. They could also consider whether to give funds to family members sooner rather than later, updating their wills, and/or increase donations to charity.

Beryl then disclosed that they have eight grandchildren at different stages in their lives. Some are good money managers, and some are at the other end of the spectrum. This was causing them grave concern.

This is where further advice is critical. There will be a large unrealised capital gain on the shares, which could be mitigated if their wills are drafted in such a way that the managed funds go to those grandchildren who intend to keep the funds intact. Testamentary trusts are also an option.

I recommended that Beryl and her husband talk to a solicitor who specialises in estate planning, and involve both their accountant and a financial adviser, to draw up their wills in both a tax effective and a fair manner.

Thanks to compound interest, this couple are facing one of the best problems for any investor to encounter: how best to use and bestow plenty of money. I concluded our phone conversation by reminding her of the Chinese proverb: “Best cashews come when teeth are too old to chew.”

 

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. noel@noelwhittaker.com.au. This article is genral information and does not consider the circumstances of any investor.

 

4 Comments
Bob
January 18, 2021

I see. That makes sense. Save more than you need for your own lifetime so that you can pay your estate solicitor, accountant, and financial adviser

May
January 15, 2021

Yes Noel, I can’t agreed with you more ‘have the cashews when you still have good teeth’. I do not understand about work & balance when I was young. I worked in health care & I worked every Saturday, Sunday & Public Holiday to built up my retirement nest eggs. Now I retired, but my knees limit my travel. As well when we safe to travel again after this pandemic, I might be too old!!

Ramani
January 14, 2021

Like every other human construct, compound interest can help or harm consumers depending upon where the consumer is. As an investor / saver, patience will pay dividends. The same works in reverse as a borrower, which every defaulter knows to her or his cost, and eventual bankruptcy.
Within this, the frequency with which interest is compounded is important. Nominal interest rates can mislead as more frequent compounding results in a higher effective rate being realised (or paid as a borrower). Hence the advice for mortgagees to repay more frequently - especially if interest rates are high.
Whether to take interest earned in cash or leave it being compounded depends on the rate on reinvesting exceeds the compounding rate.
Noel has thankfully served the public so long in increasing financial literacy. This task is an ongoing challenge.

George
January 14, 2021

A great reminder, Noel. I often wonder why I have so much money when I never had the highest paying job and I never found the big investment payoff. Late in life I realised it was simply the passing of time and compounding over 40 years. Of course, it helped that market returns have been strong and even TDs paid well in the past.

 

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