We’ve all heard the saying ‘time is money’ when someone talks about business, and quite rightly so. If you don’t make use of your time you won’t be making any money. But this cliché is also the centerpiece of successful long-term investment. The longer you stay invested, the faster the value of your portfolio will grow, and this effect accelerates over time. The result is that portfolio values grow exponentially with time. Later we will show that if you have enough time (within reason) you can have $1,000,000 by investing as little as $405 per month.
In this blog we look at why time is so important to growth when investing, the practical implications of this relationship, and finally how to take advantage of this phenomenon, ultimately turning time into your friend, rather than your enemy.
Why does this happen?
The simplest way of illustrating this concept is to imagine that you have a bank account with $1,000 in it. You put no extra money into the account and you don’t make any withdrawals. For simplicity, lets assume the account pays interest of 5% and there are no fees.
After 1 year you will have $1,050 in your account, having earned $50 ($1,000 × 5%) in interest, plus your initial investment of $1,000. Therefore, after the first year your investment is made of $1,000 capital and $50 interest on the capital:
But in the 2nd year things get more interesting. Once again you earn $50 interest on your initial investment of $1,000, but you also earn 5% on the reinvested interest from the 1st year. This interest earned on interest is referred to as ‘compound interest’. Therefore, in the 2nd year you earn an additional $2.50 ($50 × 5%) in interest.
Although the extra $2.50 seems very insignificant, this is the part of the return that grows exponentially over time. Let’s look at what happens in the 3rd year. Once again you earn 5% on your initial $1,000, plus 5% on the $50 interest from the 1st year, plus 5% on the $52.50 interest from the 2nd year. All up this is $55.13 interest in the 3rd year.
As you can see, even though you will always get $50 on the original $1,000, each year there is an additional piece of compound interest. Each year the interest earned on interest will increase by more and more, and this is the reason why the saying ‘time is money’ is very relevant to investing. To show the full impact, the following image shows the above example but over 30 years.
This image illustrates the power of time. Your original investment stays at $1,000 over time. The interest on the original investment increases by the same amount each year, $50. This results in the value of the account increasing in a straight line. But the increase resulting from compound interest grows larger and larger each year, and rather than resulting in a straight-line increase, it results in a curve that gets steeper and steeper over time. At the end of the period it is the compound interest that represents by far the greatest portion of the account value.
Although we used a simple example of a bank account, these principles apply to any type of investment, whether it be shares, property, bonds, or anything else.
What does this mean for investments?
The simplest and most important implication of all this is that the longer you stay invested, the better the long-term outcome is. Morningstar applied the above principles to determine how much needs to be saved each month to have a million dollars by the age of 65, assuming a net return (interest rate) of 7% p.a. The results are shown below:
On the left the image shows the monthly amount that needs to be invested to reach $1,000,000 by the age of 65, when starting to invest at different ages. This once again shows the exponential impact that compounding returns has. Clearly it is much easier to reach the target of $1,000,000 by starting to invest earlier.
On the right hand side the figure shows how much of the final $1,000,000 is made up of your capital (the money you saved), and how much is the return generated on your savings. The person starting at the age of 25 has more than 80% of the million dollars made up of earnings and only had to contribute about $195,000 of their own money. The person starting at age 55 had to put up about $700,000 to reach the same target.
Clearly there are significant long-term benefits to investing sooner rather than later. One investment that can be taken for granted is superannuation, however this is one of the best vehicles to take advantage of time, given that we can’t access it for so long.
How do I take advantage of this?
To make the most of compounding returns, you need to stay invested as long as possible. Even if you start with a small amount each week/fortnight/month, and build it up over time. As shown by Morningstar, smaller amounts over longer time periods can have a significant impact. Some tips to help maximise long term growth are:
Have a goal to work towards and stick to it. Remember we want to take advantage of time so it will take a while to see significant gains. Don’t get put off by feeling like progress is slow initially.
Have your savings/investment account separate and not readily accessible. This will help stop you from withdrawing your savings and keep funds invested for longer timeframes.
Set up automatic transfers or savings plans. It is usually a good idea to have these transfers happen on the same day as you get paid.
Review the amount you are saving at least every six months, and make small increases whenever possible.
There are many investment products out there, each with different features and suited to different circumstances. There may be benefit in speaking to a financial advisor to make an informed decision.
If you would like more information, or to discuss anything with an advisor please contact us, request a call back or book an appointment using the links in the contact us section of the website.
For more interesting investment infographics from Morningstar click here.
Disclaimer: The information provided in this presentation is of a general nature only. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions. Please seek personal financial advice prior to acting on this information.