If you invested $100,000 for 20 years and it earned 8% per year, you would end up with an asset value of $466,096.

Not bad huh? Your money more than quadruples, and all you need to do is be patient.

But what if you left it an extra 5 years?

After 25 years, you would have $684,847.

It took 20 years for you to experience growth of $366,000, but only 5 more years for you to gain a further $218,000. It’s disproportionate right?

Let’s roll forward another 5 years.

At the 30 year point your $100,000 investment would be worth a touch more than a million dollars. Over 10 times your original investment!

What I want you to really focus on is the acceleration in growth as we extend the time frame.

In the first 20 years $366,000 was gained. But in the next 10 years, half the duration, $540,000 was gained.

If you’re a visual person like me, try to picture this in graph form. In the early years your portfolio rise gradually, but with each year, the line heading upwards steepens. Your growth in wealth gets more rapid with each succeeding year.

This is the most important concept in finance to understand – compounding.

Warren Buffet is the richest person in the world. Why? Because he began investing at 14 years of age, and he’s had the good fortune of living to 94 (and still going). That’s a lot of time for compounding to take effect.

That theoretical $100,000 I mentioned at the start – compound that by 8% over 80 years and you end up with $47million!

Now Warren didn’t have $100,000 as a 14 year old, but he’s also done better than 8% per year.

The headline piece here when it comes to the wealth creation magic of compounding is the time frame – the longer the better.

But the rate of return also has a significant role to play. The best way to think about this element is to consider how many years it takes for your savings to double at a given rate of return. In my Financial Autonomy book I have a table breaking this down that you might want to take a look at.

If you invest such that you earn 5% per year, your money will double about every 14 years.

At 8% it will double every 9 years.

We don’t have infinite life spans. And most us aren’t smart enough to starting investing at 14 years of age like Mr. Buffett. Our superannuation is likely to be our longest investment, and that probably has a lifespan of around 40 years for your accumulation phase. Money is progressively added in to your superannuation pot, so the simple math’s that we’ve done so far with the lump sum at the beginning is not a true reflection of the outcome for your retirement savings. Nonetheless we can provide an interesting illustration

Let’s say you reach age 50 and you have accumulated $500,000 in superannuation. Your goal is to have the choice of retirement at age 60, so we have a 10 year time frame.

We know that a 5% return we’ll see your money double in 14 years, ignoring your contributions over that time, so within this 10 year window there’s not quite enough time for it to double. Your balance will get to a little over $800,000, (plus contributions)

If instead you invested your money so that it earned 8% per year, your balance will have the opportunity to reach almost $1,080,000 (plus your contributions).

So here we have two scenarios, both with the same time frame and starting value but one with a higher rate of return. The higher return amplifies the impact of compounding, resulting in your retirement savings being $280,000 greater than would have been the case with a more conservative investment allocation.

Were you to work through to 65, giving us a 15 year time frame, the differential would be even more stark. At the 5% rate of return your money just over doubles in value, coming in at a little over $1,000,000. But at an 8% return your money is able to double twice over, with your balance reaching almost $1.6 million.

Same time frame, same amount of effort from you, (none, other than having the discipline to leave it alone), but the extra return compounded over 15 years produces a $600,000 differential in outcome.

So compounding is about investment time frame, the longer the better, but it’s also about the rate of return that you generate over those years. A relatively small increase in rate of return, compounded over many years, leads to a very significant difference in outcome.

The take away then – invest for as long as you can, and be as aggressive with your investments as you can tolerate, without being reckless. We’re talking about investing here, not gambling, never confuse the two.

Another aspect of the magical effect of compounding over time can be seen in the popular phenomenon of today, the concept of the Bank of Mum and Dad. This is where parents are increasingly helping their children purchase their first home.

In most cases, parents who can afford it are giving their children a gift to help with the deposit. This is in effect an early inheritance.

For those able to provide this level of generosity, the compounding impact is indeed significant. Giving your daughter or son, $50,000 to help them purchase a property, perhaps when they’re 30, would be the equivalent of you leaving them in inheritance of around $900,000 30 years later when you pass away. And due to the impact of gearing on a property purchase, this estimate is likely to be at the low end. Beyond the simple math’s of long term compounding, our tax system also offers the benefit of no capital gains on the increase in value of the property, so your gift at this early phase of life has quite a monumental impact on your children’s long term financial security. It’s not something that’s affordable to all, but certainly, if it’s something that is doable for you, it’s well worth trying to make it a reality.

Compounding Key Points:

Lengthening your investment time frame has a huge impact – start as early as possible, and keeping investing for as long as possible.
The rate of return is the second important piece. A slightly higher return, when applied to a long period of time, has a huge impact on your ultimate result. The return amplifies the impact of investment frame. That being the case, don’t be too conservative with your investments. It comes at a huge cost.

If you need advice on how to invest your money, that’s exactly what we do at Guidance Financial Services. Book an appointment online or in person below.

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