Financial planning is really about… the miracle of compound interest

(Or why long term investments are the best investments)

Compound interest is a basic financial planning principle. The idea is simple: reinvest investment earnings rather than spend them. Reinvesting means investments will grow at an increasing rate. Each year the previous year’s earnings are re-invested, and they too earn, so that next year even greater earnings are achieved, and then reinvested, and so on through the decades.

The process is slow at first. But as time passes it gets faster and faster. It’s an exponential function. If you assume 10% per annum growth (and remember Australian shares averaged 9.5% pa and Australian property averaged 9.8% pa in the two decades to December 2014 – see the Russell Long Term Investing Report) the investment’s value will double every seven years.

If you start with $100,000, and it grows by 10% a year, over time it looks like this:

Investment on savings-over-40-years

As you can see, the difference is startling depending on what net interest you earn (and therefore what your costs are) and when you start makes an incredible difference to the end result. It’s critical to get on that green curve as soon as you can!

Exploiting the principles of compound interest drives financial planning. Looking at the graph you should notice at least three phenomena:

  1. It takes a while to get started but eventually each seven-year increase is greater than all the other increases combined. This is why we urge clients to take a long term view, and to think in terms of decades, not years;
  2. deferring the program by seven years means you have 50% less at the end, which is why we urge clients to start investing as soon as possible; and
  3. a small difference in annual return creates a big difference over time, which is why we urge advisers to minimise costs, such as management fees and interest, to maximise the amount reinvested every year.
The Dover Group