Power Of Compounding

I have often written about the power of compound interest. But I am still getting many queries asking what kind of investments offer compound interest. As one reader pointed out, the banks are only paying about 1.5% if you’re lucky, even though she has heard me mention returns of up to 9% per annum.

The essence of compounding is that the earnings are added to the capital which increases the overall rate of return. The process works so well that even small increases in the rate of return can make massive differences over time. You can use the compounding effect in interest-bearing accounts by letting the interest build up, or you can use it in managed funds such as quality share trusts by having the distributions added to the capital instead of being paid to you.

It’s a bit more difficult with investment property because the capital gain is automatically added to the property value, and you can’t reinvest the rental income in the property unless you use it to speed up the loan repayments. But what you could do is invest the rental income in something like an index fund – that would give you an overall compounding effect. You mention a rate of around 9% – that is what the Australian sharemarket has done over the last 30 years if income is reinvested. The numbers are normally something like 5% growth, and 4% income. It’s important to start early because the effects of compounding magnify over time.

Of course, money you have in superannuation automatically enjoys the benefits of compounding because the money can’t be withdrawn until you reach your preservation age. But as we are in a new financial year it might be worthwhile reminding ourselves of the difference in the retirement portfolio that a slight change in the rate of return in your superannuation fund can make. Think about a person aged 25 now, and who has $20,000 in superannuation from employer contributions, and who earns $45,000 a year. We’ll assume their salary increases by 4% per annum until they retire at age 70.

If their fund earns 5% per annum their final balance would be  $1.4 million –  if their fund earned 9% the final balance would be $4.33 million. That’s a difference of   almost $3 million. You can run the numbers for your own situation on the Superannuation Contributions Calculator on my website www.noelwhittaker.com.au