The wonder of compound interest
"The most powerful force in the universe is compound interest."
Albert Einstein
So what is compound interest?
It's really just when you earn interest on your interest, but over time this can make a huge difference to the value of your investment.
For example, when an investment return is first calculated, interest is paid on the original investment amount. The second time, interest is paid on both the original investment and the previously earned interest. So each time you earn a dividend, distribution or income payment from your investment you just reinvest it by buying more units or shares. Your original investment plus the additional investments then have the potential to earn more distributions. You then reinvest these earnings and so on.
The alternative to compound interest would be 'simple interest' where interest is calculated just on the original investment amount. This would happen where the investment income payments aren't reinvested. For example, if they were paid into your bank account and used for day to day expenses.
Example - Compound interest vs Simple interest
These figures compare the difference in value between compound and simple interest over 20 years on an initial investment of $10,000 and an annual return of 8% after fees.
| |
Investment value |
8% compound interest |
Investment value |
8% simple interest |
| Year 1 |
$10,000 |
$800 |
$10,000 |
$800 |
| Year 2 |
$10,800 |
$864 |
$10,000 |
$800 |
| Year 3 |
$11,664 |
$933 |
$10,000 |
$800 |
| Year 4 |
$12,597 |
$1,008 |
$10,000 |
$800 |
| Year 5 |
$13,605 |
$1,088 |
$10,000 |
$800 |
| Year 6 |
$14,693 |
$1,175 |
$10,000 |
$800 |
| Year 7 |
$15,869 |
$1,269 |
$10,000 |
$800 |
| Year 8 |
$17,138 |
$1,371 |
$10,000 |
$800 |
| Year 9 |
$18,509 |
$1,481 |
$10,000 |
$800 |
| Year 10 |
$19,990 |
$1,599 |
$10,000 |
$800 |
| Year 11 |
$21,589 |
$1,727 |
$10,000 |
$800 |
| Year 12 |
$23,316 |
$1,865 |
$10,000 |
$800 |
| Year 13 |
$25,182 |
$2,015 |
$10,000 |
$800 |
| Year 14 |
$27,196 |
$2,176 |
$10,000 |
$800 |
| Year 15 |
$29,372 |
$2,350 |
$10,000 |
$800 |
| Year 16 |
$31,722 |
$2,538 |
$10,000 |
$800 |
| Year 17 |
$34,259 |
$2,741 |
$10,000 |
$800 |
| Year 18 |
$37,000 |
$2,960 |
$10,000 |
$800 |
| Year 19 |
$39,960 |
$3,197 |
$10,000 |
$800 |
| Year 20 |
$43,157 |
$3,453 |
$10,000 |
$800 |
Total value recieved |
$46,610 |
$26,000 |
Reinvesting your distributions
Reinvesting the distributions or dividends you receive from your managed investment fund or direct shares is a simple but effective strategy. It gives you the potential to 'compound' your investment returns. And the longer you reinvest, the more effective it can be. So you could reach your goals sooner.
What to consider next
Speak to your financial adviser or choose an option here:
The information contained in this document is based on the understanding Colonial First State Investments Limited ABN 98 002 348 352 AFS Licence 232468 has of the relevant Australian laws as at 1 July 2009. This document is not advice and is intended to provide general information only. It does not take into account your individual needs, objectives or personal circumstances. You should assess whether the information is appropriate for you and consider talking to a financial adviser before making an investment decision. Product Disclosure Statements (PDS) for products offered by Colonial First State are available from colonialfirststate.com.au or by contacting us on 13 13 36. You should read the relevant PDS and consider whether the product is right for you. Past performance and awards are no indication of future performance.