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The concept behind compound interest is very straightforward. Simply put, it is interest earned on interest. It relies on the investment of two things; earnings and time. The more important of the two could be said to be time, given enough time even smaller investments can grow substantially by the time you reach retirement. The problem most people struggle with is deciding too late to make use of compound interest or not having the knowledge or experience to know where best to invest it.
The biggest mistake people make is starting too late. As little as ten years can make a significant difference. For example, Jack invests $20,000 at a fixed rate of 5% at the age of 25. Buy the age of 50 Jack will have $67,727. However, Jim waits until he is 35 to start investing. He invests $30,000 at the same 5% interest rate and by the age of 50 Jim has $62,368. So Jack has $5,359 more than Jim despite investing $10,000 less. It could be said that Jack is better off than Jim by £15,359. By the age of 40, Jack has already doubled his investment which will not happen to Jim until he reaches 50. The lesson here is to start investing early. Investors with less to spend need not be deterred, the principal is the same whether you invest $100 or $100,000. The earlier the better, it might seem pointless to only invest small amounts, but getting started now means when it is time to begin investing seriously you will have more savings and therefore more options.
Planning your savings can involve using several complex sums. A useful little shortcut is to divide the number 72 by the interest rate, this gives roughly the number of years taken to double your investment. Known as the 72-year rule, it was first used by Sorrentino and Zischang and can be helpful in setting your goals.
One of the biggest challenges of making use of compound interest is knowing where to invest it. Before the financial crash of 2007 savings accounts had interest rates of around 4%, making it a safe and relatively smart investment option. However, since the crash, savings rates rarely sit above 1% which scarcely outgrows inflation. Online saving accounts are slightly better than than those run by financial institutions averaging around 1%, but this is still very low. With savings accounts being almost worthless (for making good use of compound interest) new investors are better off seeking other options. The safest options being zero coupon bonds and non-speculative portfolios made up of blue chip stocks and investment grade bonds. Higher risk options involve the contrarian approach of buying stocks after a drop in the market or investing in more volatile stocks. Every individual is unique and as such different options suit different situations. Good knowledge and research is the key to finding which option works best for you. Or seek out the advice of an expert to help you find your ideal investment.
With interest rates being so low, a popular way of taking advantage of compound interest is to reinvest dividends. Dividends are regular payments by a company/government to its shareholders. Most shareholders treat these lump sums as disposable income when in fact they can be reinvested. By investing these dividends, the compounded interest is much higher, meaning greater savings for the future. This slightly unorthodox method of compounding has proven to be a much more effective method for growing savings.
In any case, saving for the future can be a complicated and daunting prospect. The best advice you can receive is to do your research. No matter where you chose to invest a poorly researched investment is unreliable and often unprofitable.
In general, don’t rely on one investment only, the key to growth and making the most of compound interest is to seek a diverse range of investments. Spreading out your investments allows for the best outcomes. It is not hard to make use of compound interest, the problem most of us face is not knowing exactly how to make use of it or the benefits it can provide. Start early and make the most of the time you have now.
Everyone is different and has different needs, if in any doubt about what option would be best for you then talk to a financial adviser. At Infinity, a financial adviser can assist in two ways; identifying your situation and finding an investment strategy to suit you. By finding out your objectives, circumstances and attitude to risk an adviser is able to grasp of the kind of strategy you are looking for. Their job is to then seek out the best investment solution for your particular situation. This not only saves you time but cuts out some of the major risk involved for new investors. By establishing long-term, working relationships with both our clients and partners we can work out the best solutions and continually adapt your investment to your particular needs as they change.
This article was written by Rebecca Jones. Rebecca is studying Finance at the University of St Andrews and is working as a summer intern in our Hong Kong office.
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