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If, like me, you’re a beginner investor, you’ve undoubtedly heard the term ‘compound interest’ being hurled about. We all know what interest is, right?
Interest – as we learnt in EMS lessons and economics classes – is the amount of money that a lender (such as a bank) receives for lending out money. Essentially, interest can be seen as the price you pay for the privilege of being able to borrow.
Similarly, you can also gain interest by investing your money in shares or simply by leaving it in the bank. In the same way that you pay interest to lend money, the bank – or a borrower – pays you interest in return. This is because banks use your money to offer loans and lend people money to buy things like homes and cars.
So what is compound interest, then?
While regular interest is worked out using the original amount, compound interest takes both the initial amount and the accumulated interest. This is described by most financial experts as ‘interest on interest’.
And why is this important, you ask?
Quite simply, compound interest allows you to grow your money much faster because the interest is calculated on both the amassed interest and initial outlay.
In an article published on BizNews, African Bank described it as a ‘snowball effect’. “As the interest paid out grows, so too does the rate at which you earn interest.”
Okay, so it allows me to grow my money. But how?
This is where it gets interesting. If you invest R10,000 (at 5% compound interest pa) you will have earned R500 in interest after 12 months. This will bring your total amount up to R10,500. As the second year passes, your investment increases to R11,025. This demonstrates the power of compound interest in a simple way.
The benefits are clear to see. How do I make this work for my future?
Future is the key word. The fruits of compound interest are sweetest over long periods of time. Former head of public sector and corporate consulting at Liberty Corporate, Mathias Sithole, told BizNews how it works over prolonged periods of time:
“For example, assuming you can earn interest of 10% per annum on an investment of R5,000, after five years, your investment would be worth R8,053 under the compound interest scenario. By contrast, under the simple interest scenario, your investment would be worth only R7,500. Likewise, after 40 years, your investment would be worth R226,296 under the compound interest scenario as opposed to only R25,000 under the simple interest scenario. Obviously, had you decided to put your money under the mattress, it would have remained at R5,000.”
Last week, I asked you to send me your finance and investment queries. Here, Johan Steyn, CFA* of Stellenbosch University shares his expert advice by providing answers to your questions.
This is a question that many employees ask themselves. The answer, unsurprisingly, is that it depends. It depends on the type of pension fund your employer offers. Typically, employees can choose different underlying funds or options aligned with their risk tolerance. For example, you have to choose between a conservative, moderate, or aggressive portfolio. The underlying asset allocation between these options would differ. There are, however, some employers who do not provide alternatives and only have one fund that they contribute to on behalf of employees. In this case it would be a good idea to diversify your retirement savings across a number of managers.
History has shown us that no investment manager or investment style outperforms consistently, therefore a diversified approach tends to produce the best outcome over the long term. Keep in mind that if you do choose to make a lower contribution to your employer-linked pension, then a lower deduction will reflect on your payslip, along with a higher amount of income tax. SARS allows you to claim back any RA contribution you made with after-tax income, however this only happens at the end of the tax year when you complete your tax return. So you lose the time value of those rands that are stuck with SARS until they pay you the refund. All the best.
- Johan Steyn, CFA is a lecturer in Investment Management from the Department of Business Management at Stellenbosch University. He holds a Masters in Investment Management and has a background in Fund Management.
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