The power of compounding
If South Africans, who are notoriously poor savers irrespective of economic conditions, could understand the power of compounding they might be more inclined to save. Once described by Albert Einstein as the 8th wonder of the world, compounding can multiply the value of an investment exponentially over time.
For example, if you’d invested R10,000 in 1974 in the FTSE/JSE All Share Index (ALSI) it would be worth R2.6 million* today, which equates to a compound annual growth rate of 17.2%. The same amount invested in cash would now be worth R747,000, a compound annual growth rate of 13.1%.
“It’s interesting to note that the difference of 4.1% in the annual growth rates doesn’t begin to convey the scale of the difference in rand terms, a multiple of 3.5 times,” says Rob Formby, director of retail operations at Allan Gray.
The first step in making compounding work for you is to start saving. Statistics show that South Africa saved a meagre 15.4% of GDP in 2008, which compares poorly with the likes of India (at about 30%) and Brazil (at around 25%) and Australia at 22.5%. It is, however, in line with the US at 13.1%, the UK at 15.6% and New Zealand at about 16%. Gross savings includes corporate, government and household saving; the picture is even worse for household savings, says Formby.
“According to data from the South African Reserve Bank, currently households are no longer saving but actually spending capital,” says Formby.
The second step is to give your money time to work for you. The sooner you start saving, the longer you will have to benefit from compounding. “As the time allowed for compounding increases so the amount of growth, relative to your contributions, increases exponentially.”
The third step is to look at wealth creation in terms of real growth rates. Obviously the higher the returns the more pronounced the compounding effect. But this isn’t the full picture, as the example above doesn’t take account of the effects of inflation. “To get a true picture of wealth creation you need to bear inflation in mind in order to get the value of your investment in real terms,” says Formby.
The inflation rate since 1974 has averaged 10.5% per year. Thus, an investment of R10,000 would have to be worth R333,125 today for it to have keep pace with inflation. Adding inflation into the equation, the ALSI investment created 5.5 times the amount of real wealth compared to the cash investment.
*An investment in an Allan Gray share portfolio at the same time would have grown at a compound growth rate of 27.9% and be worth R55.6m
