Last week one of my readers challenged some of the claims I had made in one of my articles. So I felt, it was only right for me to provide some more clarity and explain the most basic and powerful ways to accumulate wealth – that is, the power of compounding. Compounding is the reinvestment of income at the same rate of return to constantly grow the initial invested amount, month on month and year after year.
To demonstrate lets take a look at the hypothetical case I had provided in 9 Biggest Investor Mistakes & How to Avoid Them Like A Ninja.
We had made some assumptions of with two people, Jane and John. Jane decided to start saving KES 20,000 a year at age 19 and John started saving the same amount at age 27 when he finally had a great paying job.
Making various assumptions, here is a simplified draw-down of this on an excel sheet below:
If Jane stopped saving at age 26 for various reasons – maybe she gets married and kids come along quickly making her a stay at home mum, at an annual return of just 10% per year, she will managed to accumulate KES 10,351,480 by the time she is 65. On the other hand, John saved continuously KES 20,000 until he was 65 but in contrast to Jane he only managed to accumulate KES 8,831,850.
It is clear that Jane managed to accumulate much more over time by saving only KES 20,000 for eight years and surpassing Johns investment with a significant difference of KES 2,139,630. Meaning that even with the modest amounts, when allowed to compound at relatively low rates but over long periods of time, add up to really staggering sums of money – that is the power of compound interest.
In the end, Jane had only invested a fifth of the amount of shillings but has 25% more to show for it. Your take home here is that the sooner you start saving for retirement, the sooner you will be able to achieve financial freedom.
Please note that this simple power of compound interest has made Warren Buffet one of the most successful investors of all time and he has written extensively on it. In various letters he wrote about the art of investment, most interesting of them is the one he challenged the soundness of Queen Isabella’s decision to fund Christopher Columbus’s expedition to find a new route to Asia in which had the queen opted instead to invest the $30,000 (the initial investment for expedition) at 4% instead, it would be worth over $7 trillion today. He also discussed King Francis’ decision to commission the Mona Lisa in 1516, which according to Warren, Ferdinand’s $20,000 would be worth well over a $1 quadrillion if he’d only manage to invest it at a 6% annual rate instead.
So why not harness it for yourself? It has been tried and tested. So, just act rationally, stay consistent, start early and think long-term.
Happy Investing!