Why Interest Compounding is a Powerful Tool for the Youth

If I was in my early twenties today, one of the things I would drive to full strength is the power of compounding. Well, I'm not going to get that young again and didn't quite understand this beneficial force when I was that young. So, I somehow missed my opportunity and that's why I'm channeling that principle to those who can gain full advantage of it. Compounding is a tool anybody can use to build wealth, but, in the hands of the youth, it is an awesome weapon. If fully understood and put to work, it is a potent force to transform seemingly little bits of resources into a pot of fortune. Some financial experts call it "the eight wonder of the world", a phrase often attributed to John D. Rockefeller. Renowned scientist, Albert Einstein is cited as having described it as "the greatest mathematical discovery of all time". What has never been disputed is that money that is invested on compounding basis, will, over a long stretch (especially 30 years and more), balloon to a size that ordinarily seems disproportionate to the sum invested. That ballooning effect is the handiwork of compounding. How will every young person understand this and go to work immediately with a tool that assures great results?

What Compounding Is
Compounding basically relates to interest application, though I prefer to give it a broader meaning. As you most likely know, interest is applied on simple or compound basis. The different there is that while the former creams off the interest, the latter re-invests it as part of the principal. In effect, the principal continues to grow, enlarged at each point of interest payment by the accretion of current interest earning. Interest payment could be at monthly, quarterly, half-yearly, yearly or other agreed interval. Interest compounding is therefore that interest payment system that capitalises the interest. This fact is generally known. What is not usually obvious to everybody is what impact this compounding process can produce over a relatively long period. Well, I will show you. If you are familiar with the fact but are not putting it to active use, this is a reminder that compounding can do a lot to build wealth for you.

But first, to my point about a broader meaning. I choose to see compounding in a wider perspective that goes beyond interest payment. If I buy a stock and keep it, and re-invest all its earning over the same stretch as interest could be earned, I have compounded the investment. Even if, for portfolio management reasons, I have to sell the stock along the line but still re-invest the money in new stock, I see the process as remaining in tact. In effect, re-investing and non-liquidation are the key. Over a fairly long period, any of these would produce startling results.

Some Illustrations on Compounding
Let's use some examples to visually check the impact of compounding.

First, let's use some figures that are sizeable but still realistic for a lot of young people today who receive lump-sum payments at work. James stretches himself to invest N500,000 at a compound interest rate of 10%. He disciplines himself to keep to consistent annual additions of N500,000 and leaves the investment for 30 years, his planned point of retirement. If compounding is done monthly, James will pick up N105 million, even though his total actual investment will be N15.5 million. You can check interest compounding with this calculator.

Take John who chooses to shoot for investment returns of up to 20% per annum. He also logs in N500,000 at the outset, and targets an annual addition of N200,000, also re-investing all the earnings on his investment. He invests in carefully picked stocks that meet his returns objective and risk tolerance. If he achieves the annual returns target over the duration of the investment, his closing investment value will come to N402 million.

Okay, let's consider a lower investment range. Segun can squeeze out N100,000 to invest for 30 years, compounded annually. He expects to achieve annual returns rate of 20% on the investment, but is unwilling to make any additions on an on-going basis since he wants to invest using other vehicles. Computed, Segun's single N100,000 investment will be worth N38.4 million, 30 years on.

We could go on and on and you can indeed do so, using the online compound interest calculator. The results point to one thing: it pays heavily to begin early to take advantage of compounding. Altering the parameters produces a dramatic impact, into the distance. If you increase the investments or raise the rate of returns, you will in many cases be shocked at the multiplier effect. Don't wait till you are old to begin to put investments to work. You get more outstanding results when your investments have enough time to duplicate over and over. The wise thing to do: take every step you can to load up investments, early on. When will find relatively less pressure to deal, later in life, as the results of your early investment actions would have blossomed.