‘Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it’ – Einstein.
Investing is one of the most powerful things you can do to build wealth for the long-term. Simply put, it’s your money making more money over time, through a concept known as compounding.
In this article we examine what Compound Interest is and give investors access to Syfe’s powerful Compound Interest Calculator.
What is Compound Interest?
Compound interest refers to the interest an individual earns on both the initial amount invested or deposited in addition to the interest earned over time.
Let’s break down that concept.
If you put an initial deposit of $100,000 in a savings account that earns 4% interest per year, by the end of year one you would have $104,000.
$100,000 + 4% = $104,000
In year two, you would now earn 4% interest on top of the $104,000 you finished year one with, meaning that by the end of year two you would have $108,160.
$104,000 + 4% = $108,160
In this example, you’ve earned – or compounded – the interest on your initial deposit + the interest you earned over time (from the year prior). Over longer periods of time, the impact of compound interest can ‘snowball’, allowing individuals to greatly accelerate their investing and savings ambitions.
Which Products Earn Interest or Yield?
Investors have a variety of options to choose from to earn interest or generate a yield, including: savings accounts, Syfe’s Smart Baskets, dividend paying stocks, and REITs.
It’s important for investors to realize that while products like savings accounts carry virtually no risk of loss, when you invest in assets like dividend paying stocks or REITs – there is a chance that your initial investment can decline in value.
In saying that, dividend yielding stocks or high yield Smart Baskets do tend to earn higher yields than products like savings accounts, creating opportunities for more risk tolerant investors.
How to Harness the Power of Compound Interest
To truly take advantage of compound interest there are three things investors need to think about:
1. Stay Invested
The number one tip for harnessing the power of compound interest is to stay invested for the long term. As you will see from the comparison table below, the benefits of compounding snowball as time goes on, growing greater still over longer time periods. By being patient – investors can reap the rewards of compounding – if they stay invested.
2. Develop a long term mindset
Tying into the first point, it’s important to cultivate a long term mindset so that you can actually benefit from compounding. By thinking in decades not days you will be more mentally equipped to deal with inevitable market volatility and price fluctuations, which will allow you to stay invested over the long term.
This habit of regular investing is also known as dollar cost averaging (DCA). There are several advantages to this strategy. First, DCA can help you cushion the impact of market fluctuations. By consistently investing a fixed sum of money over a period of time, you end up buying more shares when prices are low and fewer shares when prices are high. Over the long term, the cost of your investments are averaged out.
DCA’s other benefit is psychological. Because you’re investing consistently regardless of market conditions, your emotions are removed from the equation. For example, most people prefer avoiding losses more than they like winning – a behavior formally known as loss aversion. When the market plummets, some investors may panic and sell at the market bottom. If you’re dollar cost averaging, you’ll instead be purchasing your investments at an attractively low price.
While there is nothing inherently wrong with investing with a short term mindset – as we’ve highlighted with the table above – the full benefits of compounding are unlocked over longer periods of time.
3. Set specific financial goals
Without a goal it’s easy to become distracted, whether that involves selling investments too early, investing in a way that is actually against your ambitions, or investing outside of your circle of competence. Beyond just setting a goal, it’s important that your goals are specific. For example, having a goal of ‘Building a $150,000 investment portfolio to use as a deposit for my first home purchase’ is much more useful than ‘I want to build a large investment portfolio’.
With Syfe’s powerful Goals feature, you can easily set, track, and invest against your biggest goals – from financial independence to saving up for a house deposit. Learn more about Syfe Goals now.
Smart Baskets are pre-packaged orders formulated according to investment attributes of the underlying securities/ETFs (such as geographic and industry exposure, historical dividend yield, and historical capital appreciation), and do not take into account your personal circumstances, risk appetite, and goals. The information provided does not suggest or imply and should not be construed as any guarantee of future performance, or as investment advice or strategy. Each Smart Order comprises several separate orders for ease of execution only, and should not be construed in any manner as a managed discretionary account or a managed investment scheme. Investing involves risk, including the risk of losing your invested amount. Any information that may be in this communication is general in nature only and is current at the time of writing. Syfe does not make recommendations of any kind or provide personal advice that take into account your objectives, financial situations or needs. You should therefore consider the appropriateness of the information in light of your own objectives, financial situation or needs before acting on such information, and/or speak to your financial or tax adviser for personal advice. Past performance figures are based on information provided by third parties and may not be accurate. Any references to past performance and future indications are not, and should not be taken as, a reliable indicator of future results. Syfe does not intend for any statement made here to relate to the acquisition or disposal of any shares in the companies or other financial products named here. Syfe makes no representation and assumes no liability as to the accuracy or completeness of the content of this communication.
