When we look to build our wealth, it can be tempting to focus on finding the right investment or the right time to invest. But there’s another factor that can make a meaningful difference over the long term: time.
The longer your money is invested, the greater the opportunity it has to benefit from compounding.
Compounding is one of the most powerful forces in the world. Just ask Albert Einstein, who’s said to have called it the “eighth wonder.” It’s a relatively simple concept, but understanding how it works can help explain why starting earlier, and taking a long-term view can matter.
What is compounding?
At its simplest, compounding is what happens when you earn returns not only on the money you originally invested, but also on returns your investment has previously generated.
Imagine you invest $10,000 and it earns a return of 5% over a year.
At the end of that year, your investment would be worth $10,500, before allowing for fees and tax. If that entire amount remained invested and earned another 5% the following year, the return would be calculated on $10,500 rather than the original $10,000.
Over time, that process snowballs.
Of course, actual investment returns don't arrive at a steady 5% every year. The value of investments will rise and fall, and returns can be both positive and negative.
For example, returns will vary depending on what your investment option invests in.
That's why an example like this is useful for explaining how compounding works, rather than predicting what an investment will earn.
Time gives compounding more opportunity to work
The effect of compounding will become more noticeable the longer money remains invested.
To illustrate, imagine $10,000 was invested and assume an after fees, before tax, return of 5% each year, with all returns remaining invested, and assuming no additional contributions or withdrawals:
These figures aren't a forecast or an indication of the return an investor should expect.
They're simply a mathematical illustration of compounding using a constant assumed return.
The interesting part here is the amount of additional growth generated over the longer time periods.
But markets don't move in a straight line
In the real world, investment returns go up and down. Some years will be stronger than others, and investments can fall in value too. So while the examples above help show how compounding works, actual investment growth won’t follow such a smooth path.
Starting earlier versus investing more later
A common misconception is that you need a large amount of money to start investing - this is not necessarily the case.
Starting earlier gives money more time to experience investment returns and for those returns to compound.
That means it's never “too late” to begin investing. How much you invest, the investments you choose, fees, tax, market performance, withdrawals and your timeframe will all influence the result. But it does help explain why putting off a long-term goal can have an impact that's difficult to recover with time alone.
Playing the long game
Compounding isn't particularly exciting from one month to the next. Its potential becomes more apparent over longer periods, as returns have the opportunity to build on returns.
For long-term investors, the lesson is less about trying to find the perfect moment to invest and more about understanding the role that time invested can play in working towards a financial goal. Small decisions today can become part of something much bigger over time.
Important information
This article is general information only and is not personalised financial advice. The worked examples are hypothetical and assume a constant 5% annual return, with returns reinvested, and do not allow for fees or tax. Actual investment returns will vary and can be negative.
Past performance is not a guarantee of future returns.
SBS Wealth is a Class 2 Financial Advice Provider. Before investing, we recommend you obtain personalised financial advice. Past performance is not an indicator for future returns.
SBS Wealth Limited ("SBS Wealth") is a wholly owned subsidiary of Southland Building Society, operating as "SBS Bank" and is the issuer and manager of the SBS Wealth KiwiSaver Scheme and SBS Wealth Investment Funds (collectively the Funds). SBS Wealth is also the provider of the SBS Wealth Portfolio Service (DIMS). For more information see the SBS Wealth KiwiSaver Scheme Product Disclosure Statement or the SBS Wealth Investment Funds Product Disclosure Statement available from this website and the register of offers of financial products at www.disclose-register.companiesoffice.govt.nz.
You can also view the SBS Wealth Portfolio Service Disclosure Statement on this website.