/ 29 July 2011

Another take on ‘time is money’

There is no such thing as "get rich quick".

There is no such thing as “get rich quick”. Those of us who chase after the massive returns advertised in the business pages more often than not lose our entire investment. And there’s no doubt an obsession with quick returns results in poor financial decisions with negative long-term consequences.

Rather than chasing this “fast money”, investors should resign themselves to the fact that it takes time to make money. An investor wanting to accumulate wealth is best served by the basic investment principles, because it’s time in the market and not timing the market that delivers.

You will be amazed at how quickly your capital grows if you save regular small amounts and leave these amounts untouched in an appropriate financial product. The reason these funds grow quickly can be explained by the savers’ version of the “time is money” adage, compound interest.

There are few more compelling arguments to convince the layperson of the importance of saving. The fountain of online knowledge Wikipedia (www.wikipedia.org) defines the compound interest phenomenon as “adding accumulated interest back to the principal amount, so that interest is earned on interest from that moment on”.

The magic of compound interest doesn’t exhibit over an hour, day or month, but rather over periods spanning many years. How does it work?

A conservative saver with R10 000 to invest will probably favour a bank-issued savings product offering the best available interest rate at the time. For this example we will assume a money market account paying 6% per annum, credited to the account each month.

In the first month the bank calculates the interest payable on the R10 000 and pays it into your account. But each month thereafter the interest is calculated on the principle amount plus the accumulated interest. After 10 years, the balance in the account is R18 193.

An investor who draws down on this interest each month has an entirely different experience. Assuming the same initial investment and interest rate, this investor would receive the principle amount of R10 000 after 10-years.

They would also have received 120 monthly interest payments (a fixed amount of R50 each month) for a R16 000 total. The impatient investor sacrifices R2 193.97 by choosing not to compound the interest. A similar situation develops in the world of equities.

Had you invested R100 in the South African equity market in 1961, and left the investment untouched, it would have topped R283 489 by 2006. The secret to this stellar return is the 18.9% annual growth achieved by reinvesting dividends.

Had the investor opted to receive the dividends — and no doubt spend the windfall on various cost of living expenses over the years — the investment would have grown to a disappointing R35 479. Each rand contributed by a saver who starts saving for retirement at age 25 has a decade longer to deliver.

Jaco Gouws, Max Investments product manager, Old Mutual South Africa, equates retirement saving with a spaceship launch: “You spend 80% of your fuel during take-off, but once the spaceship passes a certain point it flies smoothly with minimal consumption.”

The first 20-odd years of your retirement saving process is similar to the take-off. You do the hard work early, but then sit back and let the compound interest and re-invested dividends ‘pad’ the rest of your savings journey.

The challenge is to communicate this “time is money” message to the broader public. Because, unless we do so, Joe and Jane Average won’t appreciate the power of compound interest, nor the requirement for investment discipline over the long term.