Start Investing Early – Remember the Power of Compounding

Many people assume they can hold off saving for retirement and make up the difference later. But this can be a costly mistake. Waiting too long to start saving can make it very difficult to catch up, and only a few years can make a big difference in how much you’ll accumulate. Why is it so? The answer lies in the power of compounding.

To take advantage of compound interest and receive a substantial return on your investment, you should invest as early as you can and for decades. That way, your nest egg can withstand market corrections. This is true for those who make fixed amount of saving each year as well as for those who invest in other instruments such as stock market, unit fund, etc.

Those who started early will have advantage because they have decades until retirement, which makes a huge different compared to those who are approaching retirement age. Even if those first contributions are small, they become significantly larger over time through the power of compounding,

To understand why compound interest is so great, you have to see it side by side with simple interest. Let the numbers do the talking!

In this example, we are using a starting principal balance of $10,000 and a 10 percent interest rate. With simple interest, the principal balance remains the same throughout, but with compound interest, the interest payment is rolled into the principal each year.

compound_interest

As you can see, at the end of 10 years, you receive more than 50 percent more money in interest payments with compound interest ($15,939) than you do with simple interest ($10,000). Compounding occurs when you reinvest your earnings (in this case the interest) and those earning earn! This phenomenon allows for exponential growth of your money.

Back to the world of investment, you can apply the same principle of compound interest into stock investing. Should you invest in a stock worth RM5.00 that produce Earning Per Share of RM 0.30 for instance, this is a 6% return. If company declares dividend of RM0.10 while keeping the remaining RM0.20 as retained earning, how does this help growing your wealth? In a layman term, discounting all other factors, the RM0.20 retained earning will help to grow the RM5.00 you initially invested by helping the company to earn more profit in future. Of course we assume that the company does make good use of the retained earning for future expansion and business growth.  What happen to the RM0.10 per share dividend you receive? If the company does provide Dividend Reinvestment Plan just like what Maybank does, then it is basically a form of compounding your dividend by adding into your stock holding., With market price of RM 5.00 per share for example, RM0.10 will entitle you to own 0.02 unit of share in the company. If you own 2000 shares, you are entitled to 40 extra shares adding into your ownership. (0.02 * 2000 = 40). Alternatively, one should reinvest the dividend received by purchasing into other value stocks of his choice. With that, the money does get an effect of compounding as compared to just keeping it under the pillow.

 

 

 

 

 

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  1. Pingback: Money Tips Topic 14-Jan | Financial Savvy

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