Beauty of Compounding Interest

Malaysians in general tend to overlook the power of "compounding interest" when it comes to investing. Many of us are investing with the goal of obtaining a huge amount of profit/gains in the shortest amount of time. Hence we fall easily into so called "investment" gimmick that promises ridiculous returns in the shortest possible time. 

Take for example a gold investment scheme launched in Malaysia a few years ago. The scheme promised about 20% return per month! With such attractive returns and a well organized marketing strategy, many investors were coerced into investing huge amount of money. Alas in 2009, the company managing the investment scheme was raided by BNM for charges of money laundering and illegal deposit taking. I believe investors whom invested into the scheme have yet to get back their investment as all assets belonging to the company running the scheme were frozen by Bank Negara as the trial is still ongoing. Read more HERE.

Now the objective of this article today is not to highlight about the fallacy and greed of investors but to create an awareness that utilizing the power of compounding interest can be a safer and more effective way in building your retirement wealth. 

Albert Einstein once quoted the following;

“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

Despite being a pioneer in the field of physicist, this very person is able to appreciate the power of compounding interest which lead to him naming it the eight wonder of the world. 

What exactly is compounding interest?

Wikipedia's definition as follows:

Compound interest arises when interest is added to the principal of a deposit or loan, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding

Example of compound interest:

Investor A has RM1000 in hand. He decides to place that money into a Fixed Deposit that guarantees a return of 4% per year. What would the total amount he will have 20 years from now?

Calculation:

• Investor A places RM1000 into a fixed deposit account. 
• At the end of Year 1, the 4% return upon invested amount (RM1000) will entitle him to earn an additional RM40 worth of interest. 
• Hence by the end of Year 1, Investor A has RM1040 in his FD account. In order to make use of the power of compounding interest, Investor A does not make any withdrawal and waits for Year 2 to arrive.
• At the end of Year 2, the 4% return would now be calculated upon the amount available in his FD account. In this case RM1040. 
• A 4% return on RM1040 would entitle Investor A to earn an interest of (4% x RM1040) = RM41.60
• Current balance in Investor A FD account now stands at RM1081.60

By not making any withdrawal, Investor A is utilizing the power of compounding of interest. Just by earning interest upon interest, year after year, Investor A's initial investment of RM1000 to grow astronomically as illustrated in this table below:

Initial Amount		MYR 1,000.00
Year	Interest	Amount at Year End after interest paid
1	4%	MYR 1,040.00
2	4%	MYR 1,081.60
3	4%	MYR 1,124.86
4	4%	MYR 1,169.86
5	4%	MYR 1,216.65
6	4%	MYR 1,265.32
7	4%	MYR 1,315.93
8	4%	MYR 1,368.57
9	4%	MYR 1,423.31
10	4%	MYR 1,480.24
11	4%	MYR 1,539.45
12	4%	MYR 1,601.03
13	4%	MYR 1,665.07
14	4%	MYR 1,731.68
15	4%	MYR 1,800.94
16	4%	MYR 1,872.98
17	4%	MYR 1,947.90
18	4%	MYR 2,025.82
19	4%	MYR 2,106.85
20	4%	MYR 2,191.12
21	4%	MYR 2,278.77
22	4%	MYR 2,369.92
23	4%	MYR 2,464.72
24	4%	MYR 2,563.30
25	4%	MYR 2,665.84
26	4%	MYR 2,772.47
27	4%	MYR 2,883.37
28	4%	MYR 2,998.70
29	4%	MYR 3,118.65
30	4%	MYR 3,243.40

Key Findings

• Within 20 years (in yellow), Investor A has doubled his initial investment amount of RM1000 to RM2191.12.
• If he continues for 30 years (in green), Investor A will triple his investment amount of RM1000 to RM3243.40

Key Factors That Effect the Returns from Compounding Interest

1. Interest

The higher the annual interest, the faster the investment grows. For example if Investor A invest into an investment vehicle that guarantees a return of 8% per annum, his investment of RM1000 by the end of 20 years would be RM4660.96. 

At the end of 30 years, the investment value would be RM10,062.66. 

2. Period of Investment

As illustrate in the table, the longer Investor A remains invested without making any withdrawals, the more effective compounding interest would be. 

From the table shown in the sample calculation, you can see that Investor A doubles his investment amount of RM1000 within 20 years and triples it within 30 years based on a fixed interest of 4%

3. Initial Amount Invested

If Investor A were to place RM10,000 instead of RM1,000, the amount he would earn via compounding interest is also 10 times.

Let's illustrate all 3 Key Factors into this table below:

Intial Amount		MYR 1,000.00
	Interest 4%	Interest 8%	Interest 16%
20 Years	MYR 2,191.12	MYR 4,660.96	MYR 19,460.76
30 Years	MYR 3,243.40	MYR 10,062.66	MYR 85,849.88
40 Years	MYR 4,801.02	MYR 21,724.52	MYR 378,721.16
Intial Amount		MYR 10,000.00
	Interest 4%	Interest 8%	Interest 16%
20 Years	MYR 21,911.23	MYR 46,609.57	MYR 194,607.59
30 Years	MYR 32,433.98	MYR 100,626.57	MYR 858,498.77
40 Years	MYR 48,010.21	MYR 217,245.21	MYR 3,787,211.58

Summary

What I have just written is just a basic example of Compounding Interest. There are more complicated compounding interest involving varying frequency of additional contribution to the investment as well as varying interest. I hope to explain further about it in my next article.

As for now, if you are already doing some Financial Planning of your own, you can utilize this method to projected the amount you will have in the future based on your savings kept in FD or in any investment vehicle that promises fixed return yearly. 

Despite the simplicity of compounding interest, it is through sheer patience and discipline that one is able to fully maximize the power of compounding interest. When one projects the returns via compounding interest, one can then truly appreciate the value of their savings and ultimately create a barrier of resistance towards attractive dodgy investment schemes.

Cheers and Happy Investing

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