I reckon one of the wonders of the investment world is the power of compound interest.
But what is it and why is it so powerful?
Compound interest is simply the concept of earning income on income. You do this by reinvesting the income from your investments. Even small investments can become very large investments. The earlier you start the bigger the miracle. So the key is starting as early as possible.
There are plenty of examples and the numbers can be quite staggering.
Let’s take shares in the Commonwealth Bank of Australia for example. If investors had picked up $10,000 worth of CBA shares when they were first floated (1991) they would be worth about $110,000 today. Better still, had they reinvested all the dividends along the way the $10,000 would be worth $432,000 today.
Why do investors often miss out?
First, investors may be too conservative in their investment strategy. They may opt for lower returning defensive assets like cash or term deposits. Cash or term deposits may avoid short term volatility but they won’t build wealth over the long term.
Second, investors leave it too late to start contributing to an investment portfolio. This makes it more difficult to catch up in later life and leaves investors more at the whim of financial market fluctuations during the catch up phase.
Finally, investors get spooked by steep slumps in investment markets. During these times the investor switches to cash. If they return (and it’s a big “if”) it’s too late as the market has already had a good recovery. It’s hard to believe that during the global financial crisis (only a few short years ago) shares in Commonwealth Bank of Australia fell to less than $25. Recently they were changing hands at about $81.
Bye for now
Sources: The Australian Financial Review 23 July 2014 Phillip Baker
Shane Oliver AMP Capital The Power of Compound Interest and Investors Best Friend.