Compound interest can be difficult to wrap your head around. It’s like watching your children grow up. You see them every day and don’t notice any change. Then a distant relative comes to visit and looks on in disbelief at how your tiny infant has turned into a towering teenager. Or, to put it in a way that a teenager might understand, it’s like a social media post that goes ‘viral’. A piece of content is shared and liked by a few users, spreads to others and creates a ripple effect. An audience that grows and shares in turn attracts an audience that grows and shares, until suddenly the post is trending.
The point is, it’s amazing how large something can grow from a small change in conditions. If something compounds – if a little growth provides the fuel for future growth – a small starting base can lead to results so powerful it seems to stagger belief. In fact, they can be so logic-defying that most of us underestimate what’s possible, where growth comes from, and what it can lead to.
The value of getting a few extra percent
That’s how it works when compound interest is applied to your investments – when you generate ‘interest on interest’. Over many years, this will increase your next egg dramatically. And the more years you have to invest, the greater the difference will be to your returns.
Let’s imagine you have two children. Every year from the day of their birth, you give them each CHF 1,000. Child number one takes the money and puts it in a tin under their bed. Child number two invests in an accumulating fund that tracks one of the main indexes, such as the S&P500. The average interest rate is 5 percent for the purpose of this example.
On their 18th birthday, child one has CHF 18,000, while child two, who has benefited from compound interest, has accumulated CHF 29,539. That’s a whopping 64 per cent more, even though the average interest each year was only 5 percent. What’s more, because the power of compound interest begins to run wild the longer you save, the incremental increases child two enjoyed each year would continue to grow disproportionately. In fact, if the two children had kept saving in the same way until their 25th birthday, child two would have saved more than twice as much as their sibling.
Use time to your advantage
This example corroborates one of Julius Baer’s favourite mantras for successful investing, namely ‘time in the market is more important than timing the market’. Many investors devote so much time to economic cycles, trading strategies and sector bets that they forget that the most powerful and important lesson – the lesson compound interest teaches us – is simply to wait it out. To stay invested. In fact, studies show that investing in the S&P500 and simply waiting 20 years typically produces better returns than actively managed portfolios.
Warren Buffett is the most-quoted investor out there. But few people pay attention to the simplest fact: Buffett’s wealth isn’t down simply to some astonishing investing acumen but about being a good investor for an exceptionally long time. Since he was a child, in fact. That’s why he himself says “My life has been a product of compound interest.”
And that’s the lesson investors can learn from compounding. Good investing doesn’t necessarily involve chasing down the highest returns, because the highest returns can be hard to find and harder to repeat. It’s about earning solid returns that you can stick with and which can be repeated for the longest period of time. That’s when the power of compounding is unleashed.
