At some point in life, someone might have approached you with the promise to double your money and it ended in a loss of savings followed by extreme caution in making other investment decisions. The question we often ask is, “Is it possible for an investor to double their investment in the market?” And the answer is, “Yes, through the power of compound interest.”
Compounding is best explained by James Clear, the author of Atomic Habits, ” little improvements seem to make little difference on any given day, and yet the impact they deliver over the years is enormous.” Compound interest is the magic wand in the investment world that doubles investment; However, it demands time, discipline, and patience from the investor. Compound interest happens when interest earned on any investment is added back to the principal to calculate interest for the next period: it is simply interest on interest.
Money market funds in Kenya allow investors to compound their investment uninterrupted daily while the investors must be intentional about reinvesting returns from other asset classes. Dividends earned from listed companies and Saccos, and interest paid from investment in fixed securities. Dividends can be reinvested back into the company if the share price is right and coupons earned semi-annually can be invested in more attractive treasury bonds, stocks, and commodities.
There are two types of interest rates in the market: Simple interest, which calculates interest on the original investment, compound interest calculated from interest earned, and principal from proceeding periods.
The illustration below is of 2 investors: Kas and Nakaya.
Kas compounds her investment with no interruptions within the investment horizon while Nakaya draws interest earned at the end of each year.
Assumptions.
Investment horizon: 10 years
Interest per annum: 10%
Initial investment: Ksh.500,000
Kas Investment
Ksh.500,000 * ( 1.1)^10
= Ksh.1,296,872
Total principal and interest at the end of 10 years is Ksh.1,296,872: Principal invested Ksh.500,000, and interest earned Ksh.796,872
Nakaya’s Investment
Ksh.500,000* 10/100= Ksh. 50,000
Nakaya’s earned interest is drawn at the end of each year within 10 years. Total interest earned within the investment period is Ksh.500,000 less than Kas’s Ksh.796,872
Parameters that determine the power of compounding
- Time duration
The longer an investor can invest without any interruptions of withdrawing interest earned like the case with Kas the more wealth they can compound.
- Start Early
The most crucial element in compounding is time something we can all take advantage of regardless of the size of our investment. An early start provides a solid base to grow wealth with time.
An example:
Kas starts investing early with Ksh.100,000 for the next 25 years;
Assumptions
Interest rate= 10% per annum
Ksh.100,000* (1.10) ^25 = Sh 1,083,471
Nakaya starts later but doubles her investment ticket to Ksh. 200,000 for the next 10 years:
Ksh.200,000*(1.10) ^10= 518,749
Time from the above illustration is more important than the amount so start early if you can.
- Discipline
“Compounding is hard because a month can feel longer than a decade.” Morgan Hous. It is very important that an investor defines their financial goals and makes regular investments regardless of their earnings. Knowing what is your priority and understanding how discipline pays off later will help you develop the habit to keep money aside for investing.
- Patience
Most of us approach the financial markets as a place where we can get quick returns and get disappointed when we receive different results.
The long-term investments that powerfully reap big returns need time to compound.
These are some of the great rules you need to know about compounding:
Rule of 72
This is used to determine the time it will take to double your investment.
For example, if an account was paying a compound interest of 24%, then it could take 3 years (=72/24) for your investment to double.
Rule of 115
It is used to determine how long it will take one to increase their investment 3 times if they are earning compound interest on it.
For example, if your investment is earning a compound interest of 5%, it will take you 23 years (115/5) to triple the amount invested
Rule of 144
It determines how long it will take to increase the amount invested 4 times if earning compound interest.
For example, if a company has been growing sales at 24% in the last four years, then it is likely to increase 4 times in the next 6 years (144/24).
Rule of 240
Used to estimate how long it will take to increase your investment 10 times if earning compound interest.
If for example, a company has been growing sales at 20% over the last five years, then you can confidently project it will take 12 years (240/20) for a company’s sales to increase 10 times.
Are you ready to double your investment using the right tool, compounding?
By Kasiva and illustrations by William Momanyi, founder of Magic Compounding.
MA Financial Services Consultants