Many investors obsess about returns. They want to know which asset class or which fund manager is outperforming because they want the highest possible growth on their money.
This is not illogical. Anyone putting their money to work by investing it should want to know that it is delivering a good return.
It does, however, place too much emphasis on something that is entirely out of their control. How the markets perform in future, or whether a fund manager will beat the index or its peers is not something that anyone can foresee, or influence.
This focus on performance also tends to be short term in nature. Investors want to know what their returns have looked like over one year, or three years, or even five years. Yet investing is never about those kinds of time frames. It is about benefiting from market growth over decades.
Plus, in reality, when investing over the long term, how markets or fund managers perform is not the most powerful influence on the outcome. Rather, it is time itself. It is benefiting from the power of compounding – earning growth on top of growth.
Control what you can
Investors who appreciate this also understand that this is something that is in their control. The earlier they start, the greater the effect of compounding will be.
This can be illustrated by a simple example.
Twin brothers Fred and Bob both start working on the day they turn 20. Fred immediately saves R500 every month and does so for the next 10 years. At the age of 30, however, he stops.
Bob, on the other hand, delays saving until the day he turns 30. From then on, he saves R500 every month until he and his brother both retire at the age of 60. Both of them receive the same annualised return of 10% on their investments.
Over this full period, Fred would have put away R60 000. Bob would have saved a total of R180 000 – three times more. Yet, because Fred started earlier, his investment would have grown to nearly double that of his twin brother’s.
|The power of time|
|At age 20||R500.00||R0.00|
|At age 25||R39 863.85||R0.00|
|At age 30||R104 629.53||R500.00|
|At age 35||R172 147.90||R39 863.85|
|At age 40||R283 236.48||R104 629.53|
|At age 45||R466 011.51||R211 189.09|
|At age 50||R766 732.90||R386 512.49|
|At age 55||R1 261 512.49||R674 973.65|
|At age 50||R2 075 577.77||R1 149 581.36|
As this table shows, despite making more contributions, Bob is not able to catch up.
In fact, if Bob (and his descendants for generations to come) never increased the R500 contribution, he (or they) could never close that gap. The 10-year head start that Fred had on them means that his money would forever continue to compound at a faster rate than they can top up their capital.
Give it time
This is a hugely significant fact, and one that Nedgroup Investments recently used in another rather mind-boggling theoretical experiment.
Nic Andrew, executive head of Nedgroup Investments, asked what would happen if the parents of twins, such as Fred and Bob, set up tax-free savings accounts for them on the day they were born and then immediately began making the maximum allowed contribution, which is currently R33 000 per child, per year. The lifetime cap on a tax-free account is currently R500 000, but Nedgroup Investments assumed that the government would increase this over time, as this is what has tended to happen around the world.
If the twins’ parents continued to save the R33 000 per child each year until they turned 18, they would have invested about R600 000 for each of them. Since the intention is that this money is for the long term, it would be 100% in growth assets – local and international equities. Historically, these have provided returns of 7% above inflation over long periods.
At this point, two important things happen. The first is that the parents stop adding to the investments. The second is that Fred and Bob don’t withdraw the money to buy themselves matching BMWs. Instead, they leave it where it is and allow it to compound.
The result, as Nedgroup Investments found, would be spectacular.
Making it work
“Amazingly, by investing a relatively small amount early, not withdrawing and instead compounding over a long period of time, by the time the twins reach retirement at 65, the balance would have grown in today’s money to over R20 million,” says Andrew. “This means the retiree twins could each withdraw R130 000 per month in today’s terms and the money would last until they were 100.”
And, significantly, those withdrawals would be entirely tax-free.
To put that in context, in order to match that outcome, Fred and Bob would have to start saving R3 700 per month from the day they turn 18, and increase that contribution every year by the rate of inflation. If, however, they were instead given this gift by their parents, they would never have to save for retirement at all.
That, in turn, means they could save for their own children in the same way. Just like their money would be compounding, the social impact too would be compounding.
“The point of this story is not to encourage a new generation of Trust Fund Children – it’s simply to illustrate how profound the effects of long-term saving can be,” Andrew notes.
“This is a fantastic example of three fundamental concepts of successful investing: the magic of compounding, especially over very long periods; the importance of investing sufficiently in growth assets that earn returns well above inflation; and ensuring that taxes and costs do not erode your net return.”