[imagesource: Khan Academy]

Compound interest, at school, was a headache that made maths problems just that little tougher to solve.

My school days are a speck in the rearview mirror at this point and I can safely say that my thoughts on compound interest have changed.

In terms of investing, simple interest means you only earn interest on the initial amount you invested. Compound interest, on the other hand, is described as “interest on interest” and shows the power of starting to save early.

Consider this little sum posed on Moneyweb:

…would you rather have R1,000 per day for 30 days or R1 that doubled in value every day for 30 days? Those in the know would choose the doubling of R1.

Why? Because, at the end of 30 days, they would have accumulated over R500 million – versus the R30,000 they would have if they had opted for R1,000 per day.

Obviously, that is a very simplistic illustration because your money isn’t going to double at that sort of rate.

The so-called ‘Rule of 72’ does offer us a more accurate portrayal of how and when your investment would likely double and what means over an extended period of time.

Relax – it’s not as hectic as that image above featuring the dreaded ‘log’ makes it appear. It’s actually rather basic:

Simply take the number 72 and divide it by the interest earned on your investments each year to get the number of years it will take for your investments to grow by 100% or double…

For example, if an investment returns 10% per year it will double in value in about seven years. Conversely, for an investment to double in seven years it needs to earn a 10% annual rate of return.

I probably don’t need to elaborate further but why not.

If your investment only returns 4% growth per annum, you’re looking at 18 years before it doubles.

What this rule really drives home is the importance of starting to save and invest early. The consequences of decisions made today will bear fruit over the years, based on the sound principles applied at their inception, which is something Consequence Private Wealth understands very well.

Let’s look at Investor A and Investor B.

In the case of Investor A, he invested R2 000 a year into a portfolio from the age of 24 to 30, which grows each year by 12% (net).

…although he stopped saving after he reached age 30, he left the money invested where it continued to earn 12% each year until he retired at age 65.

Investor B on the other hand carried on spending his money for another six years before he started saving R2 000 per year at age 30, also earning 12% (net) per year through the same advisor.

However, Investor B was able to continue investing R2 000 per year until he retired at the same time as Investor A, i.e. at the age of 65.

At the age of 65, both A and B would have around R1 million.

Work out how much each investor put into that portfolio and the power of compound interest is laid bare.

Perhaps now is the time to reach out to a trusted financial advisor so you can make the most of that power.

[source:moneyweb]