The power of compounding
Compounding returns are a key principle in wealth creation and understanding how it works is the first step toward reaching your investment goals. Put simply, compounding means earning returns on the returns you earn over time. In the short term, its effects can be relatively minor. But longer term, compounding has the potential to increase your returns exponentially. Consider this example.
Let’s say you start with an initial investment of $10,000. And on that you earn 10% p.a. every year after fees and tax. After your first year you’d have $11,000 (your initial $10,000 + 10% returns = $1,000).
By the end of year two, your investment is now $12,100 ($11,000 + 10% = $1,100). The thing to note is that compared to the previous year your returns have increased by an extra $100. That’s because you earned 10% on your invested sum, and also 10% on the returns from the previous year. Now that extra $100 might not seem like much. But using this example, after ten years your initial investment would have grown to $25,937 and the returns earned that year would have risen to $2,358. That’s the power of compounding.
The example below shows the effect of compounding and is for illustrative purposes only. Neither the growth rate nor the cash value is guaranteed.
Investing can be a great way to generate wealth and secure your long-term financial future. But before you begin, it’s sensible to first decide what you’re setting out to achieve, how you’re going to achieve it, and by when.To begin this process, a good first step is to set a goal. For instance, are you saving to purchase a property or perhaps you’re investing for retirement? Or maybe you want to simply grow your wealth. Whatever the reason, after deciding why you’re investing the next step is to determine how much money you need to achieve that goal and over what timeframe. This will reveal what sort of average return you’ll need to achieve to reach that goal, and whether your goal is realistic. This information forms the basis of your investment strategy, but you should also consider:
- The amount of time you have to achieve your goals
- The sorts of assets you’re comfortable holding
- Your overall appetite for risk versus return (how much capital you are prepared to risk)
- The current value of your portfolio and what additional contributions may be required
- Adopting an active management approach (constant monitoring and rebalancing)
Risk is a fundamental part of investing. While it can’t be completely avoided, there are ways you can manage it. One proven way to mitigate some risk is a process called diversification. A diversified investment is one where you hold different types of assets (bonds, shares, property, cash etc.). By spreading your money across a number of asset classes you protect yourself should any one asset perform badly without sacrificing too much potential gain. Over time, a diversified investment typically helps you achieve smoother and more consistent returns. The way you diversify your investment will largely depend on three key factors:
Time. Investors with a longer time horizon may feel more comfortable in taking on assets with more risk because they have time to offset any short-term market volatility. By contrast, investors with a less time are less likely to be comfortable taking on risk, as they are more vulnerable to a short-term market loss.
Risk. Different assets classes carry varying degrees of potential risk and return. For simplicity, an investor might choose to adopt a conservative, moderate or aggressive approach when diversifying. A conservative investor will want to protect their initial investment (called capital protection) but this typically achieves lower returns. By contrast, an aggressive investor seeks much greater returns but exposes their initial investment to more risk. It’s also possible to change your risk profile. For instance, as your time horizon shortens it’s likely you will shift to a more conservative approach.
Goals. Your investment goal and time you have to achieve it plays a large part in deciding which sorts of assets you’re likely to choose. If you don’t include enough risk in your portfolio, you may run out of time to achieve your goal. Conversely, carry too much risk and your money might not be there when you want it due to a market downturn. As a general rule assets like cash, fixed interest and bonds have a lower risk profile while property and shares are higher risk.
If you choose to diversify your investment, it makes sense that some assets are going to outperform others. Over time, this difference in performance alters the overall percentage of each type of asset you hold. And that means you might be inadvertently exposing yourself more or less risk than you’re comfortable with. Rebalancing your investment is something you should consider doing every six to twelve months, and is simply a process of assessing how each type of asset has performed and reallocating funds between them to ensure they remain in their desired percentages.
However you choose to invest, there will be fees for doing so. And each investment firm will apply their own fee structure, which is likely to differ from other firms. So before you invest, it’s important to understand all the expenses associated with each type of investment. Lower costs give you a greater share of the returns on any given investment, which helps you maximise things like the benefits of compounding returns. Over time, even small differences in costs can have a big impact on performance.
Milford Funds have a capped management fee which is used to pay fund related expenses such as fund administration, research, company visits and trustee costs. The Milford KiwiSaver Plan also has a monthly administration fee. In addition most Milford Funds have a performance fee. This is applied only when we exceed the performance objective for any given fund. For example if a funds objective is to return 10% p.a. after fees and tax, and the fund returns 12%, a performance fee is taken from the 2% additional returns. The performance fee ensures our interests are wholly aligned with our clients’, so when our clients do well, we do well.