**COMPOUNDING OF INVESTMENT RETURNS**

*In running there is a tricky challenge to start the year. In the “January Challenge” people try increase their distance by a single kilometre each day. So, on the very first day of January the goal is to complete one km. On the second one needs to complete two km, increasing this to three km on the third day. This running challenge is a great example of how compounding works which is the topic of this month’s Financial View.*

### The January Challenge

As mentioned in the introduction the aim of the January Challenge is to increase the mileage each day by a single kilometre. With the final goal of completing 1km on the first day of the month and 31km on the last day of the month. The simple chart shows the linear increase applied each day.

We did also mention in the introduction that this is a tricky challenge. The reason that it gets tricky is that after a very short period one is completing significant distance each subsequent day without rest. To go out and do 1km on the first day is relatively simple. Perhaps 10km on the 10th day is easy for some but consider that in the final week (or final seven days) one would need to complete 196km (or more than two complete Comrades – the equivalent of running from Durban to Pietermaritzburg, turning around and running back).

The simple addition of just one additional kilometre each day takes you from a stroll around the block to something beyond the reach of most of us. And whilst the addition of one km each day is what makes the difference the larger influencer is the mileage that you did the previous day. If the formula is “today’s distance = yesterday’s distance plus 1” then yesterday’s distance always carries the greater influence. This is very much like compounding of investment returns – what you have accumulated to date influences what your current returns will be.

We often repeat that time in the market is more important than timing the market. The longer the timeframe for the investment the greater the compounding effect. This is the same for the January Challenge, where despite the consistent increase of adding just one additional km per day the graph is very exponential.

Following the 10th day of the month you would have done total mileage of 55km. Despite being almost a third of the way through the month this is a mere 11% of your total target. 10 days later and you would be just below two thirds through the month but your accumulative mileage of 210km doesn’t even represent half your total targeted distance. The heavy lifting is done towards the end with the final 11 days being a hefty 286km, or 58%.

The important thing to remember though is that without having gone from 1km to 2km on day 2, or even 9km to 10km on day 10, without starting one would never get going.

### How this is similar to Compounding of Investment Returns

Like the January Challenge compounding involves adding on to what you already have. If you invest R1 000 and it obtains a 10% return in the first year then you have R1 100 going into the second year. If that once again returns 10% your investment grows to R1 210 etc. Your initial investment’s growth accelerates as time passes.

Investopedia defines compounding as, *“Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.”*

They key phrase is “grow at a faster rate” or as we refer to it – acceleration!

### Why is Compounding so important

There are two primary reasons why we are such big advocates of compound returns.

#### To be able to provide sufficiently for old age

General financial theory tells us that you need to put away between 10% and 15% each month over your career (average career span about 40 years) in order to provide you with sufficient capital that will replace say 80% of your income for a further twenty years while in retirement.

What we are often not reminder about is that our final salary after 40 years of working will be a lot higher than our starting salary. Compounding allows the small contribution towards retirement savings of our “small” starting salary to cover the full amount of our final salary – which should be for most people, the highest monthly income that we ever earn.

#### To generate real wealth

The reason your final salary is going to be higher than your starting salary is because your salary will increase most years with an amount to reflect promotions, job changes and inflationary increases. The impact of inflation is incredibly erosive because inflation like investment returns also compounds. When you see an inflation figure reported such as the last reported CPI of 5.9% this just represents the increase in costs of the basket of goods from one year to the next. The inflation report shows us that prices have actually increased by 20% since 2018.

We all know that what we can buy with a single R10 note diminishes each year (there aren’t a lot of things now days that you can buy with a single green rhino) to the extent now that there is a suggestion that the South African Reserve Bank introduces a R10 coin instead. Inflation has already seen the demise of the 1c, 5c and 10c coins (we won’t talk about 1/2c coins for the benefit of our younger readers).

The only way one can get wealthy is if your assets grow at a quicker rate than what inflation is eroding their value – you need a real return (return above inflation) and an increase in your purchasing power. We constantly maintain that in order to beat inflation over the long term you need sufficient exposure to growth assets such as equities.

Compounding is a powerful force, and it can be harnessed to your benefit. As Albert Einstein famously said, *“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”*

The beauty of compound interest is that it allows you to earn interest on your interest – so that while you have to sweat initially to earn the money you initially invest, from then on, your money works on your behalf. As in the running graph showing interest, you need to build your investment balance, the bigger that balance the greater the benefit of compounding a 20% return on R 1 000 is nice, a 20% return on R100 000 is better, a 20% return on R1 000 000 is very nice, but a 20% return on R 10 000 000 is fantastic.

Form the above you can see that you need to save as much as possible while you are younger, increase your contributions annually to account for inflation, try not to touch the capital, ensure you are invested in the correct asset classes and let your investments grow. Stick to your plan and you will be amazed at how over the years the compounding of returns will help you achieve your goals.

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