Money Makes Money
Sound too good to be true? How can 'doing nothing' with your money earn you more money? It’s important to remember the longer you leave your money invested, the more time it has to grow through the power of compounding.
Written by Victoria Kent, Senior Investment Specialist
This information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs.
Benjamin Franklin is credited with saying:
"Money makes money. And the money that money makes, makes more money."
He was referencing the power of compound interest – whereby money earns interest, and that earned interest then earns more interest. The value of compound interest can be easily overlooked, but it can be a powerful tool for growing your wealth over time. Some say it is THE most important concept to understand when building long-term wealth.
Let’s say you invested $1,000 at an annual interest rate of 5%. After one year, you would have earned $50 in interest. But with compound interest, that $50 would be added to your principal balance, so the next year you would earn interest on $1,050 instead of just $1,000.
This means that after two years you would have earned $102.50 in interest instead of just $100. After 10 years you would have earned $628 instead of $500. You can see how this interest can accelerate pretty rapidly over time, especially at higher rates of compounding.
It's essentially interest on interest, and its power can be mind boggling. You can have a play with the Moneysmart calculator here, or if you prefer formulas:
A = P(1+r/n)nt, where A is the accrued amount at the end of your investment period being your initial principal plus interest, P = principal or your initial investment amount, r is the annual interest rate, n is the number of times interest is compounded per year, and t is the number of years.
Sound too good to be true?
How can 'doing nothing' with your money earn you more money? Well, the reality is you are not really 'doing nothing', you are actively not drawing down on that money. It takes patience and commitment. And if you are benefitting from compounding, you have set yourself up to have a compounding situation in the first place. Well done you.
You may have done this by opening a bank account that earns compound interest, or by investing in stocks that pay dividends and offer a dividend reinvestment plan (DRP).
It’s important to remember the longer you leave your money invested, the more time it has to grow through the power of compounding. If you’re a beginner investor, it’s a good idea to start early and invest regularly, so that your money has time to grow.
In an era where we almost expect immediate rewards, an idea like patience can seem demotivating. But it's actually quite empowering to think that the timing of an investment may be far less important than the time that is allowed for it to deliver. A long-term investment horizon means we don't need to be as concerned with market volatility. You can confidently ignore the noise.
Albert Einstein is often credited with saying,
"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”.
While there is no definitive proof this quote belongs to Einstein, the essence of the statement is still immensely powerful and cannot be disputed.