Time is an important factor for all types of financial investments. However, it can be quite difficult to grasp the full impact of compound interest, which sees you earning interest today on the interest earned before. It is known as exponential growth. We are all familiar with the well-known rice on the chessboard fable:
An Indian king was so impressed with a new game called chess that he offered its inventor anything he wanted. The inventor, a sage, made a seemingly simple request: He asked that one rice grain be placed on the first square of the chessboard and that the number be doubled each successive square. The king wholeheartedly agreed, but quickly realized that he wouldn’t be able to fulfill his promise. Exponential growth was his obstacle. A chessboard has 64 squares and the 20th square already required over a million grains. At that rate the 64th square required more than 500 times the global annual rice production.
Compound interest is exponential
Let’s consider the following example:
Investor 1 invests US$1000/month starting in the year 2000 into a balanced fund and continues contributing monthly till 2004, which yielded a total of US$60000. Investor 1 stops investing, but allows the money to remain invested till the end of 2014.
Investor 2 starts investing US$1000/month into the same balanced fund in 2005 and remained invested till the end of 2014, which yielded a total of US$120000.
By the end of 2014, Investor 1 received a return of US$250000, while Investor 2 received US$110000. We find that Investor 1 received 40% more than Investor 2 despite having contributed less. The key is exponential growth, which sees their base savings grow exponentially as it earned returns.
When is the right time to invest?
Fluctuating markets and global crises are making it difficult for new investors. Making accurate predictions about the market is nearly impossible, but one thing remains true: Investors who start early and leave their investments to grow have been outperforming investors who have waited for better market conditions.
If you are concerned by equity valuations or you’re looking to diversify then a balanced fund might be for you. A balanced fund has an experienced manager make the allocations for you. This is a good option for those wanting to hand off the decision making process, but it’s always a good idea to keep yourself well informed.
Procrastination is your enemy. The markets will fluctuate, but they even out over time, which rewards the patient investors. To fully utilize the power of compound interest you need to allow your money to spend time in the market.