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.
For example, if you had $100 000 in the bank and you earned $5000 in interest, you could withdraw the $5000 or else leave it in the account. If you leave it in the account, you now have $105 000 working for you – this is called compounding.
Provided the interest rate stayed the same and you left the account alone, you would earn $5250 interest in the following year and your account balance would be $110 250. If that was left to compound, the interest the next year would be $5513 and your new balance $115 763.
Notice how both the interest and the principal are growing every year because every year you’ve got more money working for you.
If you have property, the growth automatically compounds because you can’t hack off the back patio and sell it, and if you have shares, you can join the dividend reinvestment plan whereby dividends are used to buy more shares and not paid to you directly. Not all companies offer this. Of course if you’ve got managed funds, it’s only a matter of ticking the reinvestment box.
Compounding is really that simple. If the interest is paid to you, you will find that it will be spent and lost forever. If you reinvest it, you will find yourself the proud owner of a portfolio that grows faster and faster every year.
Noel Whittaker is a director of Whittaker Macnaught Pty Ltd. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. His email is email@example.com
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