The Power of Compounding

They say that ‘compounding’ is the eight wonder of the world, and not without good reason. Despite the dismal returns from global stock markets in this decade (2000-09), over the past 100 years returns from the global stock markets have averaged 9-10% per annum including dividend income. On the assumption that returns going forward will mirror the longer term past let us take a look at the following mind teaser which works well to demonstrate the power of compounding.

In the accompanying Table below, Investor A starts to save for retirement at age 25 and puts €2,000 into his investment programme each year until he is aged 32. That’s eight years and an investment of €16,000 in total. He does not contribute anything further to his investment programme after age 32 but he continues to generate a theoretical return of 10% each year on his investment until he retires at age 65.

Now compare Investor A with Investor B who starts his investment plan later at the age of 33, just when Investor A is finished contributing to his plan. However, Investor B contributes €2,000 into his investment programme every year until he is aged 65 and gets the same theoretical return of 10% per annum. Over a period of 33 years, Investor B has put a total of €66,000 into his investment plan compared to only €16,000 for Investor A.

Now ask yourself - who has the largest lump sum saved at age 65? Surprisingly, even though Investor B has contributed €66,000 to his programme compared to only €16,000 by Investor A, it is Investor A who walks away with the bigger lump sum. The following analysis makes the point clear - by the time Investor A has stopped contributing to his investment programme at age 32, he has already compounded his monies to €25,159. A 10% return on this lump sum in the following year is €2,516 and already above the €2,000 that Investor B has just started to contribute in his investment programme. Investor B simply can not catch Investor A in the time given.

Of the €25,159 that Investor A had accumulated by age 32, €16,000 was made up of contributions he/she had made and the balance of €9,159 came from returns on the monies invested. For the first eight years then, it was more about what Investor A had invested than about then returns. But once he/she had accumulated some capital compoundimng did the rest and over the next 33 years until retirement at age 65, Investor A generated €559,162 or returns without having contributed another Euro.

Now that is the power of compounding!!

The above example should serve to highlight that the earlier you start either your investment plan or pension plan the less you will have to contribute and the more that the ‘money’ works for you.
 

Rory Gillen
GillenMarkets
30th April 2009

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