11 February 2025
The importance of compounding interest can never be underestimated, and it’s frequently hailed as a potent force that can turn small investments into large fortunes. Given its significant influence on both investors and borrowers, was dubbed the "eighth wonder of the world" by Albert Einstein.
What compounding means
Compounding returns can be explained as earning returns on both your original investment as well as on its subsequent returns.
In a world of immediate gratification, investors need to develop and strengthen their patience. It takes discipline and patience to achieve your financial goals and long-term financial success, and we have the evidence to back this thinking.
The numbers don’t lie
Let’s look at how a retirement investment grows over 40 years. Let’s assume the investment starts with a R500 monthly debit order that increases by 6% per year over the 40-year period. The investment also grows at 8% per year over the 40-year period.
It may surprise you to learn that halfway through the 40-year investment period, you probably will have accumulated only around 12.6% of the final investment value.
Interestingly, you only reach half of your final cumulative investment value in year 33 of 40 (or 82% of predicted period).
This means that you get most of your investment growth in your final years of investment. In fact, you accumulate 50% of your final investment value in the last seven years or just 18% of the total period.
This really highlights the power of compound growth and supports the statement that it is the 8th wonder of the world. Like everything in life though, there is always a ‘but’.
In the case of compounding growth, three things are true:
- You need time.
- Time is your best friend in investing.
- The longer you invest, the more profound the compounding effect becomes.
Emotion has no place in investing
Patience is the key to investing. When looking at the following set of data, it also shows that you need to take emotion out of decision-making.
The following graph shows the investment returns of the JSE All Share index from 1997 to the present, and how trying to time the market can have significant negative effects on your investment returns. A hypothetical investment of R100 000, with no sales or withdrawals over the roughly 28-year period, would be worth R3 100 000 today. Now, imagine if you were a fairly active investor that regularly switched investments and/or sold out/bought into the market, and you missed the JSE All Share’s top five performance days. Missing just those days, would leave you with R915 000 (almost 30%) less at the end of the period, than if you had remained patient and fully invested. Further illustrating the point, imagine you had missed the top 10 performance days or top 30 performance days.
The above graph ends the debate. An investor should not be trying to time the market, but rather spend time in the market.
Many believe that investing in the stock market is similar to gambling. In fact, the opposite is true. While the odds with a sports betting book, slot machine or blackjack table turn increasingly against the player the longer you play; the stock market historically rewards patience.
Over the last 96 years, through to the end of 2023, 94% of all 10-year periods have delivered a positive return for the S&P 500. Those odds are unlikely in the gambling world. (Public.com). History has shown that the longer the holding period, the greater the chances of a positive return/positive outcome.
Could you imagine what would have happened if you had made your investment at the height of each of the previous five significant market meltdowns? The answer is not what you would expect.
When comparing three indices—the JSE, the S&P 500, and the MSCI World Index—an investment in a balanced portfolio with 60% stocks and 40% bonds at the top of each market cycle performed significantly better than cash over the following ten years in every instance, apart from the 1987–1997 JSE period, attributed to political instability at the time.
This demonstrates that timing does not matter when you invest, but that investing your cash is essential for generating returns.
The key to successful investing lies in patience and long-term thinking. Timing the market or making hasty decisions often leads to unnecessary losses. As Peter Lynch wisely put it, “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.” By maintaining a disciplined, patient approach, investors can avoid the pitfalls of short-term speculation and instead position themselves for enduring financial growth.
