The Impact Of Compound Interest

Posted on: 27/04/2021

Raffi Pailagian
MBA, BSc, DipFP
Financial Planner / Managing Partner

The Secret Ingredient To Investing – Compound Interest

(00:00): Hi, it’s Raffi from Manly Financial Services here. Have you ever wondered how some people have huge returns on their property or share portfolios? Are they just lucky or are they really good investment managers? Or is there something else? Really, it’s quite easy. It’s the old adage of time in the market as opposed to timing the market, so you can let the secret of investing come into play, and that secret is compound interest.

(00:29): Now, compound interest is the worst secret out there, as it’s not really a secret at all. We learn about it at school and university, but still many people don’t put it in play long enough for it to take effect. Compound interest is earning interest on interest, and this has a compounding effect on someone’s portfolio. So let’s say I had $1,000 and I invested it in a portfolio that gave me a return of 4%. My $1,000 at the end of the year will be worth $1,040.

(00:53): If I then re-invest the $1,040, keep it invested in that portfolio, and earn another 4%, my $1,000 in year two reaches $1,082. So I’ve earned 8.2% on my initial investment over that two year period just by keeping the funds in the market for a little bit longer.

(01:13): Now, imagine what effect this could have if you were investing for five to 10 years, or even longer.

Jane & Tom

(01:19): Since I started as a financial planner, I’ve been telling the story of two people. Person A, let’s call her Jane, started investing $5,000 a year from year one to year 10 in a portfolio that earns a constant rate of return of 6%.

(01:32): At the end of 10 years, Jane keeps her investment in play, but doesn’t add any more money to the investment, and let’s again assume that it’s earning a constant rate of return of 6%. Her friend, Tom, on the other hand, decides to live it up for the first 10 years and not put any money away.

(01:48): But then after 10 years, from year 11 to year 30, Tom invest $5,000 a year into the portfolio earning exactly the same return for 20 years until the end of year 30. So, at the end of 30 years, Jane has invested $50,000 in the portfolio, whereas Tom has invested $100,000 dollars.

(02:05): They’ve both had achieved exactly the same return. So you would expect that Tom would have a lot more money as a closing balance at the end of year 30 then Jane. But the difference is that Jane has kept her funds in the market for longer and had that positive effect of compound interest on her portfolio for a longer period of time, even though she’s invested half the amount that Tom has.

(02:26): In fact, Jane, at the end of year 30, has approximately $30,000 more than Tom has and has invested half of what Tom has in this same portfolio. Her total return on investment is approximately 348%, whereas Tom’s is 95% on the amount of money that they’ve invested back into that portfolio.

Key Takeaway

(02:46): So the key takeaway from this is that investment selection or asset allocation is not the key determining factor to a client achieving their investment goals.

(02:54): The key determining factor is for a client to have the patience and discipline to put a long term plan in place and stick to that plan. That’s not to say that your portfolio won’t require the re-structuring of your asset allocation or investment selection from time to time based on market dynamics and movements.

(03:11): However, this also needs to be done via discipline and non-reactive approach so that you can use time for your benefit in the growth of your portfolio towards your investment goals and objectives. I hope this video has been a benefit to you, whether you’re a beginner in investing or a really experienced investor or something in between.

(03:28): Please like this video and subscribe to our channel and click the notification bell so you can be kept notified of future content that we’ll be dropping by this channel. And as I always say, if you need some help or assistance with any of this, please visit our website at manlyfs.com.au and get in contact with us so that we can see if we can answer your questions and help you along your journey. Thank you.

Interested in knowing more?