Rule of 72
Nicole Small, the head of education with BT Financial Services, says it was Einstein who originally described compound interest as the eighth wonder of the world. In very simple terms, compound interest is the snowballing effect of earning interest on your interest each year that you remain invested.
Let's say you invest $1000 at 6 per cent. By the end of the year you will have $1060, assuming you reinvest your interest rather than spending it. Next year you'll earn 6 per cent on $1060 - about $64 in interest, ending the year with $1124.
The best bit is, the longer you let your money compound, the greater the effects will be. In this example you'll have doubled your original $1000 by the 12th year but tripled it in year 19.
There's a rule of thumb - called the Rule of 72 - that can help you work out how long compound interest will take to double your investment. Simply divide 72 by the rate of return on your investment. If you're earning 10 per cent, it will take 7.2 years to double your money; 12 years if you're earning 6 per cent.
Peter Thornhill, the principle of Motivated Money, says investors often overlook the fact that compounding also works with share investments. He uses the example of Company X, which, each year, earns a 10 per cent return on dollars invested. Like most companies listed on the Australian Stock Exchange, Company X doesn't pay all its profits out each year to investors as dividends. It pays half as dividends, but keeps the other half to reinvest in its business.
So if company X started the year with $100 in capital (OK, so it's a small company), it would earn $10 over the year, pay $5 out to investors and reinvest the other $5. Next year it would have $105 to invest. It would earn $10.50 in profits, pay $5.25 in dividends, and start the next year with $110.25.
You can really kick compounding along by reinvesting your dividends so that you are earning future profits on all your earnings. Many popular shares and managed funds have reinvestment facilities where they automatically do it for you.
