A very important concept to help you make better financial decisions is what’s known as compounding returns, often called compounding interest.
Simply this is the fact that if you have $100 in a bank account that earns 5% interest, the first year earned is $5, and the next year you earn interest of $5.25, as you also earn interest on the interest already paid.
The compounding factor really comes into play over longer periods of times, for example an investment that earns 10% p.a doubles every 7 years (assuming you don’t withdraw any of the return).
The equal is true when thinking about debt, the interest you accrue on any debt then becomes part of the debt and next month you pay interest on the interest (unless of course you pay it off). This is why credit card debt, that is calculated monthly at 20% per annum, can severely add up.
Small increases in returns or interest make a massive difference, an amazing example is the case of the Indian Tribe selling the island of Manhattan to the dutch for around $45AUD in 1627.. Recent research has the island’s land value is worth over $2 Trillion dollars a compounding return of 6.4%. Seems like a crazy deal. However if that initial sum had been invested at 8% (the stock market return average less tax) the tribe would have over $500 Trillion! That small percentage difference over a [very ] long time cause a 250x difference. No wondering Albert Einstein calls it the 8th wonder of the world.
What does this practically mean for you and your decision making;
- Even small amounts invested early, can generate decent returns when given timey
- Leave your money invested, rather than taking it out and moving it around, so the magic of compounding is allowed to work
- Fees on investment make a huge difference, a 1% management fee can have a fairly large difference over 10-15 years
- Debt in which the interest isn’t automatically paid off, can grow very quickly(especially credit card debt)
- If you take a longer term horizon on the cost of doing something, one off purchases can cost you a decent return in the long run
The notion of compounding returns is like a flywheel, initially it feels like the returns are minimal and taking time, but after 3-5 years the momentum builds and then continues to grow, turning into something very powerful. All this takes on the investing side, is being patient and doing nothing
Always keep this in mind when making your investment and purchasing decisions as this concept will be the most powerful force in creating your net wealth.
The Money Ninja 