The Power of Compounding Interest and the Importance of Saving sooner

At the beginning of our working life we will soon be called to take some strategic decisions concerning our income management. It is important to bear in mind the goals we want to reach, the chances of growth we have and more in general our future expectations. The big problem of younger generations or even of older persons is that they don’t have sufficient financial education that will allow them to achieve a certain level of financial stability and wealth throughout their lifespan.

Some of them simply didn’t have the chance of learning it. Others, like some of my peers, simply do not consider this matter a priority and they postpone the problem. This is something I always been taught: “The earlier the better.” And it was never more true than if we were to apply this rule to an investment’s strategy. We should really think of saving and eventually investing money earlier in our life without taking any further delays. By doing this, our personal wealth will increase accordingly. How fast? This will depend on the type of investment chose together with the timing.

What if we want to speed up the growth of our personal wealth even if we are starting with very little money? Well, we should do this by exploiting the magic of compounding interest. The difference with simple interests lies in the fact that with compounding, each year earned interest is added to the original amount and thus increases the amount against which interest is calculated in subsequent years.

SIMPLE INTEREST FORMULA:

Future value = Current value ( 1 + interest rate x number of years)

This means that if we have an investment worth €100 with a 5% interest rate and we want to know the future value of our investments in 5 years, we will simply need to apply the formula and hence:

FV= 100 ( 1 + 5% X 5) = €125

COMPOUND INTEREST:

Future value = Current value (( 1 + interest rate )^ number of years)

If we were to use the same numbers from the previous example with compounded formula the future value will now be:

FV= 100 ( 1 + 5%)^ 5) = € 127.63

In the charts on the right we clearly see an example where the compound interest formula has been used for calculating the interests starting from €1000 over a ten year period at a 10% yearly return. Under the column “New Amount” we observe how in practice the aforementioned formula works on the original invested amount.

The compounding formula always generates a bigger amount.
We should also consider that the higher the number of compounding periods, the greater the amount of compounding interests.

In the example above, provided by JP Morgan Asset Management, the power of compound interest related with time is clearly shown. All three people in the example are considered to have the same annual return on their retirement funds. The first one is Susan, who invested $5000 per year for 10 years from ages 25 to 35 only; Bill who invested $5000 for 30 years but from age 35 to 65 and Chris who invested $5000 from ages 25 to 65 and hence for the longest period: 40 years. We clearly see from the graph that Chris is the one who has saved the bigger amount of money with respect to Susan and Bill.

The result of investing earlier is easily understandable by considering Susan, who only invested for a ten year period and ended up with more wealth than Bill, who saved for 30 years but started 10 years later. Even if Bill has invested three times more than Susan, because of its delay in the investment timing, he won’t be able to cope with her savings. The latter is clear evidence on how important the timing is.

Another issue could be how much money someone needs to save out of one’s salary. I always heard that 10% saving would be the right amount. I never really agreed on that, especially if you are young and need to build up from scratch your wealth. First of all everything should of course be related to your income and expenses. But if you really want to build up a proper amount of wealth starting with very little Money, you should really consider saving more, and it is actually never enough! A good saving rate is at least three times more than what people are usually told.

Especially since our economy is strongly based on consumption, professionals and economists are sometimes biased in suggesting a higher saving rate.
So if you are young and yet to start, don’t wait, act quick by combining together the following ingredients in the best possible way: savings, timing and the magic of compounding interest.