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For anyone wishing to build wealth, an understanding of the power of compounding will provide a huge incentive to get you started investing and encourage you to keep on adding to your nest egg.
Put simply, compounding is the process of earning interest on interest so if in year one your $1000 investment earns 6%, at the end of the year it is worth $1060 but the following year, the same rate of interest is earned on the principal of $1000 as well as the interest of $1060 so in year 2, interest totals $63.60.
Compounding’s greatest ally is time. The longer your money is left untouched clocking up interest on interest, the more powerful compounding gets. Let’s just say that the $1000 investment we mentioned above remains untouched for 50 years and continues to earn the same rate of interest. Its value half a century after the initial investment was made would be $18,420.
In fact, given enough time, the power of compounding can bring about astonishing increases in the worth of your investment. This is illustrated in the following table, which shows the value at age 65 of a one-off investment of $5,000 (rounded to the nearest thousand) invested at different ages with growth of 6 and 9%:
As you can see, each decade which passes significantly diminishes the compound growth of the investment and this really hammers home the importance of starting to save and/or invest early.
$1.354 million is a nice amount to earn on $5,000, but imagine the growth if you add a little each month to the pot. With an interest rate of 9%, adding $100 per month from birth to age 65 will give you a total value just shy of $5 million !!! These levels of investment are not peanuts, but neither are they pie-in-the-sky figures. What they illustrate is that slow, steady investment over a long period of time will pay dividends.
One element of the above examples that you may question is whether you can attain 9% interest on your investments, and you’d be right to do so. Certainly, putting your (or your child’s) nest egg in a savings account is not going to make them a millionaire, you need to consider other options.
While the stock market does involve risk (as does any form of investment to a degree), investing over the long term can level out the ups and downs, and history has proved that over a period of time, average yields of 9% or more are attainable. If you are interested in finding out more, one of our professional financial advisors would be happy to discuss how you can benefit from the power of compounding by investing at a level of risk that suits you.
To find out more about saving and investing get in touch today.
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