The Most Powerful Force in the Universe

When you are investing over a reasonable period of time, the ability to earn “interest on interest” really is your friend. It means you are earning interest not just on your own capital, but also on the interest you earned last year. And over the long term, this might be phrased as “interest on interest on interest on interest on interest …”.

A Simple Start

Imagine we place $100 in an investment that earns 10% pa. At the end of one year, we’ve earned $10. Imagine we spend all the interest we receive. At the end of each year, our investment amount is back to $100. That’s simple interest. At the end of 10 years, we’ll still have our $100, and we will have received a total of $100 in interest.

I = P(1+r)n-P

Don’t worry, we’ll do the maths for you, but this little formula contains a power that Albert Einstein supposedly referred to as “the most powerful force in the universe”. It calculates our net profit when we earn interest on the interest. That’s what compounding is all about.

If we re-invest the interest on our original $100, at the end of the first year we will have $110. At 10% pa, that will give earn us interest of $11 in the second year, bringing the total to $121. If we keep going for 10 years, our investment will grow to $259.37 – that’s our original $100 plus $159.37 in interest.

Time Is Money

That may not seem so impressive, but the power of compound interest really cuts in over the long term. If we go back to our simple situation, and take the interest out each year for 30 years, we will earn a total of $300 in interest. But with compounding, the total interest earned would be $1,644.94.

A child born today could easily live to 100. Simple interest on a $100 investment would amount to $1,000 over their lifetime. Left to compound, that same investment would grow to $1,378,061. That’s quite a difference!

The other critical factor is the actual rate of earnings. If the earnings rate dropped just 1% to 9% pa, our hundred-year investment would only grow to $552,904.

A Couple of Drags

There are two other things we need to take into account – tax and inflation. They act as drags on our investment performance. Let’s assume investment earnings remain at 10% pa and are fully taxable. What will our $100 grow to over 30 years at different tax rates?

0% Tax (Allocated Pension)	15% Tax (Super Fund)	30% Tax (Average Taxpayer)	45% Tax (Top Tax Rate)
$1,744.94	$1,155.83	$761.23	$498.40

As for inflation, even at a rate of 3% pa, you’ll need $2.43 in 30 years’ time to buy something that costs $1.00 today.

There are many ways of minimising the effects of tax and inflation. Picking the right tax environment is clearly important. Capital gains are only taxed when an investment is sold, so growth assets have an advantage over those that only produce income.
They also cope better with inflation.

Of course, seeking higher returns generally involves taking higher risk, but some of those risks can be managed with an effective and professionally constructed investment strategy. Talk to your financial adviser about “the most powerful force in the universe”.

KK’s Gut Instinct

Nothing to report this month!

Sporting Tip of the Month

Cadel Evans crosses the line first as Aussie’s celebrate as one.