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The Power of Compounding - Big Sky Financial Solutions

The Power of Compounding



6 February 2012

Albert Einsten descrived compound interest as the "greatest mathematical discovery of all time". For a person who made several significant discoveries in science, this statement highlights the power of compounding - that is the ability to generate long-term returns on not only the original sum invested, but earnings generated along the way.

In essence, if you put your money in an investment that delivers a return - and then reinvest those earnings as you receive them - the snowball effect canb e quite significant over the long term. This is particularly true for retirement savings, where principal is allowed to grow for many years in the concessionally taxed superannuation environment.

Compouding is the ideal 'Get Rich Slowly' scheme. All that is needed is an initial sum to invest and the patience to allow the effect of compounding to take hold. The effect of compouding can be enhanced by making additional investments along the way.

For example, let's assum you have $100,000 in your bank account and decide to put it into an investment with a net 5% annual return. Over the space of the first year, you earn $5,000 on your investment, giving you a total of $105,000. If you leave those earnings alone, rather than pull them out to spend, the second year would deliver another $5,250, or 5% on both the original $100,000 and the $5,000 gain. Your two-year total: $110,250 and climbing.

As time passes, the effect of compounding become more pronounced as more earnings are generated and that 5% return is applied to a larger balance. In face after 20 years in our example, the investment would have grown nearly three-fold to more than $265,000.

However in order to demonstrate how effective compounding is, let's consider another example. For the purposes of this example, let's assum that Jolene and Christine make the following regular annual contributions

Years 1 to 10

Years 11 to 20

Jolene

$10,000

$10,000

Christine

Nil

$20,000


Let’s assume that the investment generates a gross annual return of 8%, is invested personally, and that both Jolene and Christine are on the 38.5% marginal tax rate (including Medicare levy)

Intuitively, one would expect that making an annual investment of $10,000 over 20 years and 20,000 over ten years, at the same net rate of return, would produce a similar outcome as the total investment being made is $200,000.

In fact, at the end of 20 years, Jolene’s investment would have grown to around $344,000, while Christine’s would be $262,950; this is $81,050 or 31% higher! This is highlighted in the following graph:


In order to have a similar investment value to Jolene, Christine would have add to increase her investment to $26,000 per annum. In other words, Christine would have to invest $260,000 between years 11 to 20, to catch up to Jolene who invested $200,000 evenly over twenty years.

Superannuation can increase the power of compounding

In the above example, Christine and Jolene invested the amount they contributed annually in their personal names. What would be the outcome if the annual amount was contributed into superannuation?

The effect would be to enhance the effect of compounding due to the lower rate of tax applied to earnings within superannuation compared to marginal rates of tax applied to investing personally. Earnings in superannuation are generally subject to a maximum tax rate of 15%, while earnings generated by investing personally can be taxed at up to 46.5% (including Medicare levy).

Let’s consider what would happen if Jolene had invested in superannuation rather than in her own name using the above assumptions and that earnings in superannuation are taxed at 15%. The outcome is illustrated in the graph below:


Jolene’s investment value, by investing annually in superannuation rather than personally, has increased from $344,000 to $457,800; an increase of $113,800 or 33%. This increase is not as a result of Jolene taking on more investment risk, but simply due to the reduction in the tax applicable to the returns her investment is generating together with the compounding effect of this benefit.

Overall Jolene has increased her final investment value from $262,950 to $457,800 (a difference of $194,850 or 74%) by doing two things:

  • Starting to regularly invest earlier rather than later; and
  • Diverting the amount she invest into superannuation rather than investing personally.

The key point here is that it is generally better to invest smaller amounts now and gradually build up that investment over time as an individual’s capacity to invest increases. In addition, increasing the tax-effectiveness of returns generated can also have a significant impact.

Depending on an individual’s needs, objectives and personal circumstances, this may place them in a better position to achieve their financial goals over the long-term.

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