Noel Whittaker's Blog At a recent seminar, I was astounded to hear the speaker claim that the mathematical skills of over 50% of the population were limited to the ability to add and subtract. It was in the context that “complicated” financial terms like compound interest were far beyond the comprehension of the average person.
This paints a sorry picture because knowledge of compounding is essential if you are going to build wealth and it’s really quite simple. When you leave the earnings of an investment to compound, you leave them to grow instead of withdrawing them.
It is especially effective if you are using a managed fund.
Suppose you had $100,000 invested in a good share trust and for the year it returned 5% growth and 4% income – which is its long-term average. The capital growth would automatically be reinvested, and would give you no tax liability in that year because capital gains are not taxed until the asset is cashed in. I have long recommended that you build your wealth through regular investment in quality share trusts, and then draw down after you retire in a way that will enable you to minimise, or even eliminate, capital gains tax.
I recommend that dividends be reinvested so at the end of the first year there would be $109,000 working for you. But what about the tax on that dividend. Well, it’s a franked dividend which means it would carry a franking credit of $1714. For people earning under $90,000 a year the tax on that $4000 dividend would be minimal.
If we go to the Compound Interest Calculator on my website and enter $100,000 as the opening balance, 9% as the estimated rate of return and $5000 as a yearly investment we can see that after 30 years our portfolio would be worth $1.39 million with annual earnings of $115,000 – much much more than our annual investment.
Compounding is really that simple. If the earnings are paid to you, you will find they will be spent and lost forever. If you reinvest them, you will find yourself the proud owner of a portfolio that grows faster and faster every year.
To find out more about compounding, grab a copy my new book Making Money Made Simple. A major portion of that book is devoted to it. Available from my website www.noelwhittaker.com.au.