The power of compounding

As coined by Albert Einstein, compound interest is the "eighth wonder of the world". 

Compounding enables one’s wealth to grow and accumulate exponentially over an extended period as one’s returns generate further returns. The key to making the most of this wonder is consistency and starting early. 

How compounding works

At its heart, compounding can be likened to a snowball effect, where small, consistent contributions can result in significant wealth accumulation. Compounding refers reinvesting existing investment returns to generate additional earnings over time. The key characteristic of compounding is that returns are generated on both the principal investment and accumulated interest, as opposed to simple interest, which is earnt solely on the principal investment. 

For instance, investing $10,000 with a fixed annual return of 7% in 10 years, it will be approximately $19,670. In another 10 years, that will grow to $38,700. After a total of 30 years, that original $10,000 investment will be equal to approximately $76,120 - all without investing any additional funds. Fundamental to the concept of compound is time; time is your greatest ally.

Why do we delay investing? 

Compounding returns offer clear benefits – the fact is in the figures! However, many still delay investing. This choice may be either conscious or subconscious, depending on the individual; regardless, a handful of psychological tendencies can be attributed to it.

Firstly, people may find themselves prioritising immediate gratification over long-term rewards, which sees an increased level of spending instead of saving; this is referred to as present bias. Also, it can’t be understated that there is risk in investing. Whether that be market risk or opportunity risk, nothing is guaranteed. Fear of loss can prevent individuals from investing, even when the long-term benefits outweigh the short-term risks. Finally, there’s procrastination. Whilst it’s great to have the intention to start investing, the longer one waits, the more returns one misses out on. 

Challenges after your initial investment

Even after making your investment, be it a regular or a one-off lump sum. Behavioural biases can still weigh on one’s investment, compounding over the long term. For instance, an inexperienced investor may overreact to market volatility. During a market downturn, an investor may sell their holding and realise a loss, missing out on gains when the market recovers. Alternatively, one may chase better performance, switching holdings to the latest high-performing funds or stocks. This could see an investor buying high and selling low or unknowingly losing out on returns as transaction fees eat away at returns. It’s important to note that past performance is not a reliable indicator of future performance. Finally, investors can become overconfident; after a period of ‘wins’, some investors may develop the false notion that they can time the market, resulting in excessive trades and reduced long-term returns. 

The importance of having a financial adviser

Consulting a professional financial adviser can be critical in navigating periods of uncertainty and leveraging the power of compounding to maximise long-term wealth. A financial adviser can assist in developing personalised investment strategies that are tailored to an individual’s goals, objectives and risk tolerance. Moreover, an adviser can assist in enforcing emotional discipline and prevent overreactions to market volatility, ensuring you stay committed to your long-term investment strategy. Further, advisers can assist with regularly reviewing and rebalancing portfolios. Receiving personal advice will ensure your portfolio remains managed in accordance with your personal objectives. Finally, they can assist with professional wealth maximisation strategies, such as leveraging superannuation contributions to minimise tax payable. Working with a financial adviser ensures one can fully capture the benefits of compounding whilst mitigating the influence of behavioural finance pitfalls. Consulting an adviser to develop a well-structured plan can provide peace of mind and assist in setting up for a stronger financial future.

Conclusion

Compounding is a simple yet powerful concept that rewards patience and consistency. Whether through personal investments or superannuation contributions, allowing time and reinvestment to passively grow your financial situation can be highly beneficial. Further, it cannot be overstated the importance of having professional guidance close at hand. Employing the services of a financial adviser can further mitigate the risk of emotion detracting from performance and ensure that your investment strategy remains appropriate for your financial situation. The best time to start investing was yesterday, the second-best time is today.

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If you would like to learn more about the topics discussed in this article, please contact your local financial adviser.

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