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VIEWPOINT: THE POWER OF COMPOUNDING

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I have always thought that speaking on this topic to this audience would be preaching to the converted. However, I have had a number of interactions in the last year where the importance of this topic has been highlighted to me, along with the awareness that most of us are not using it to our best advantage.

The most recent instance was when I was helping a friend with a retirement model. As with all such models, they are wrought with assumptions. The most prevalent in a retirement model are (1) investment return, (2) inflation and (3) longevity (assuming the income you require is an absolute). While there’s very little we can do in terms of predicting (3), an awareness of the parameters of (1) and (2) is helpful. We’ll save (2) for next time and focus on (1) for now.

Albert Einstein was famously quoted as saying: ‘Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it’. Therefore to tap into this wonder, make sure you understand, but more than that (if I’m allowed to add to Albert’s quote), actively use it!

As investment return is inversely correlated to risk, you need to have a stance on your risk tolerance, as a starting point. But to emphasise the differential power: keeping all other constants as is in the retirement model I was working on, changing the investment return by 3%, added 20 years to the subject’s savings, that is their retirement money lasts 20 years longer. That is the difference between having enough savings to make it to 95 years of age (30 years post retirement) rather than 75 years of age (10 years post retirement). And this model was starting at retirement age. Can you just imagine how many more years you could add by earning a higher differential return on your savings while you are still working?

If you cannot get to grips with the added risk, avert your eyes to any fees you might be paying. While 3% in fees might not sound like a lot, I have just illustrated how it could equate to an extra 20 years of retirement wealth. An incremental increase of 0,5% in fees could take away years of savings in retirement.

So while you might not be able to replicate the Hanging Gardens of Babylon in your backyard (especially if you are in Cape Town), you can replicate another wonder.

It might not be as spectacular as the pyramids, but it is definitely more powerful. It can bring you financial security and allow you to enjoy those final years of your life worry-free. Work the wonder and earn as much compound interest as possible!

THE EIGHTH WONDER OF THE WORLD

While the classic Wonders of the Ancient World have become outdated and been replaced by the new seven wonders, the eighth wonder has remained constant throughout: compounding.  Its cumulative effect on financial wealth is astounding. Yet, it is not situated in some faraway place you need to travel to. It is in every investment and loan you own – growing cumulatively on a daily basis. But, is it working for you, or against you? Be sure to truly understand the workings of this wonder, and use it for your own benefit.

Please note that the author of this article is not a certified financial advisor in terms of the Financial Advisory and Intermediary Services Act 37 of 2002. Accountancy SA and the author cannot be held liable for any loss (including indirect and consequential loss) arising from your reliance on the opinions given in this article. Should you nevertheless elect to rely on this article, you do so at your own risk and agree to indemnify Accountancy SA and the author from any loss or damage that you may suffer as a result.

Author: Gizelle Willows CA(SA) MCom Finance is Senior Lecturer in Financial Reporting at the University of Cape Town