Imagine the scene: it’s January the second and you have made a resolution to make healthier meals for yourself and the family. After a bit of Internet searching, you find that spinach and sprouts are an excellent way to get more nutrients into the family's diet. You head to the supermarket and load up on flavonoid filled greens, but you know you face a problem: how to make a compelling case to change family eating habits? You immediately reach for the full fat butter, but then notice the red traffic lights on the nutritional content…
A similar dilemma is faced by financial coaches in encouraging clients to think about long-term savings and investments. Deferring gratification and thinking across decades is the money equivalent of eating your greens. Here, I’d like to explore how a better understanding of compounding might encourage more of us to pick up our forks and get stuck into long term financial planning.
Compounding, that is the ability of money to grow over time, Is incredibly powerful. As Einstein commented “compound interest is the eighth wonder of the world.” Its impact works because previous interest or investment returns are added to the initial amount saved or invested. Of course, if you are also regularly putting additional funds into your savings/ investment pot this impact is substantially magnified.
The important variables here are the amount regularly saved or invested, the time horizon over which this saving or investing takes place and the rate of return. Which is the most important? Well, I’d start with the first two as these are the ones over which you have most control. If you start saving and investing early and increase these amounts when possible you are doing all you can to help the process of compounding. The rate of return you receive will depend on where you put your money – for example into stocks or savings. How much these will return are outside your control, but it is worth remembering that stocks have substantially outperformed saving returns over time.
And, of course, compounding does not just work with finance, it operates in many areas of life. Building knowledge through formal or informal education, getting gradually stronger by going to the gym, adding kilometres as you work through a couch to 5K program and so on.
So, try to use the special sauce of compounding to make eating the financial greens of saving and investing for the long term more palatable. Your future self will thank you.