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The
Power of Compounding on Investments
The effect of
compounding should be the driving force behind any money
management strategy. The earlier we start saving, the
more affordable it is to build a very healthy nest egg.
Consider the following
example of three investors. Jenny, Bob and Wally. Each
has $1000 to invest and wishes to save approximately
$200,000 by age 55. Note that each has other retirement
savings in place other than this $200,000 !
Jenny was very fortunate
to have a generous grandmother who set up an investment
account with $1,000 and Jenny continues to invest $20
per month ($240 per year) for the next 50 years.
Bob starts saving later
in life, at 25 years of age with the same $1,000. Bob
needs to save a markedly higher $129 per month ($1,552)
for the next 30 years.
Wally spends up big
during his life on everything but his future. He sets up
an Investing account at 35 years of age. With only 20
years remaining until he is 55 years of age, Wally needs
to save approximately $330 per month, or $3952 per annum
to each his target.
Each of these examples
assumes a return rate of the Investment of 8% per annum.
As can be seen, the
effects of compounding are substantial. We end up with
the same nest egg, if we start Investing at an early age
with $20 per month as if we start paying $316 per month
at age 35. Not charted below, but if you leave your
start to saving until 45, you will need to save over
$1,000 per month to attain the target.
Which would you rather pay????
Figure 1 - Effects of
Compounding on an Investment over time.
Supporting Table
| Name |
Initial
Investment |
Payments
per annum |
Years |
Return |
Final
Value |
| Jenny |
$1,000 |
$247 |
50 |
8% |
$199,961 |
| Bob |
$1,000 |
$1,552 |
30 |
8% |
$199,943 |
| Wally |
$1,000 |
$3,952 |
20 |
8% |
$199,980 |
Footnote:
Spreadsheets such as
Excel make it very easy to calculate exercises such as
the above. The particular function we have used to
calculate Jenny and co’s future Investment value is
the Future Value (FV) Function
This function returns
the future value of an investment based on periodic,
constant payments and a constant interest rate.
It’s syntax is :
FV(rate,nper,pmt,pv,type)
Where
Rate is the
interest rate per period.
Nper is the
total number of payment periods in an annuity.
Pmt is the payment made
each period; it cannot change over the life of the
annuity. Typically, pmt contains principal and interest
but no other fees or taxes. If pmt is omitted, you must
include the pv argument.
Pv is
the present value, or the lump-sum amount that a series
of future payments is worth right now. If pv is omitted,
it is assumed to be 0 (zero), and you must include the
pmt argument.
Type
is the number 0 or 1 and indicates when payments are
due. If type is omitted, it is assumed to be 0.
Example of using the FV
function
Suppose you want to save
money for a special project occurring a year from now.
You deposit $1,000 into a savings account that earns 6
percent annual interest compounded monthly (monthly
interest of 6%/12, or 0.5%). You plan to deposit $100 at
the beginning of every month for the next 12 months. How
much money will be in the account at the end of 12
months?
FV(0.5%, 12, -100,
-1000, 1) equals $2301.40
In regards to our
example above of Jenny, Bob and Wally, we used the
following calculations.
| Jenny |
=FV(8%,50,-247,-1000,1) |
| Bob |
=FV(8%,30,-1552,-1000,1) |
| Wally |
=FV(8%,20,-3952,-1000,1) |
Click here
to download an Excel spreadsheet containing this
exercise.
Want to see the magic of
compounding but don’t have a calculator or spreadsheet
to calculate out? No problems. This is where the rule of
72 comes in.
The rule of 72 is
designed to help you work out, for any rate of return,
what the estimated time is for the Investment to double.
For example, an
Investment with a return of 10%, it will take 7.2 years
for the Investment to double. At 7.2%, it will take 10
years.
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