The Power of Compounding: start saving TODAY
Never underestimate the effect of compounding. It is not too late to start saving today.
When you save $1 today at a positive interest rate, you will end up with more than $1 in the future. Be it an additional $0.01 (1% interest rate) or $0.10 (10% interest rate) a year later, this additional interest will be re-invested into your principal to earn even more interest the following year.
Let's see how compounding works if you save $1 today.
Assuming a steady interest rate of 1% per year (per annum), at the end of 50 years, you would be holding on to $1.64, or 64% growth over what you have today.
Assuming a steady interest rate of 5% per annum, you would have doubled your initial investment by the 20th year. At the 20th year, you would be have $2.65, which is a 165% growth from the initial investment.
Assuming a steady interest rate of 10% per annum, you would have doubled your initial investment by the 10th year.
How to compare returns
It is important to compare growth on an annualized basis. How do you decide between
A) An investment that doubles the return over 24 years
B) An investment that yields 4% per annum, compounded?
Answer: You have to compare them on the same scale.
Principal x (1 + Yield)^(Number of Years) = Final Repayment
Investment A yields 3% per annum compounded or returns $200 at the end of 24 years for $100 invested today. While Investment B yields 4% per annum or returns $256 at the end of 24 years for $100 invested today. Thus Investment B is superior (not considering other investment risks).
Tip: Always ask for estimated annualized returns prior to investing in structured products.
For the passive investor, compounding is the way to watch your money grow without having to do anything. The trouble is in finding the right investment vehicle. Long-term investments carry significant credit risk. In return for the steady interest, you are taking on the risk that the borrower may go bankrupt and you may not get your initial investment back.
To reduce credit risk, contribute to your government savings plan. For Singaporeans, start contributing to your CPF - Ordinary and Special Accounts.
Also consider the fact that inflation rate is positive. $1 today is worth much more than $1 next year. This is also known as the time value of money. You should start saving early and regularly to at least maintain the value of your money.