I had an interesting meeting with a young client recently who was at great pains to tell me that he had managed to get off the company pension fund because they were taking too much money off his salary each month and the fund was far too boring for someone his age. He felt that he could do better with the money and his planned strategy was to go as high risk as he could for the next 5 years. Perhaps he would make a lot of money and perhaps he would lose it all…either way it did not matter: if it worked he would be very wealthy but if he lost it all it was also fine because he was young and he could start again if he needed too.
While I could not disagree about pension funds being too boring for a 25 year old (because of regulation 28 restrictions) I had to disagree with him about his ability to afford to lose it all and start again in 5 years time. What he (and most people) failed to realise is the critical importance of time in the market. Much has been written about the lack of a savings culture in SA and while there are many reasons for this, the overall cost to the economy is staggering. One of the more significant consequences is that so few people manage to retire financially independent. The ultimate cost of not starting early enough is that we don’t benefit from the power of compounding for long enough.
A few years ago there was a clever advert for one of the asset management companies which told the story of a peasant farmer who saved the emperor’s daughter. As a reward, the emperor offered the peasant anything he desired. His request was simple: one grain of rice on the first square of a chessboard and doubling every square thereafter until each square had been covered. Apparently there is not enough rice in the entire world to cover the last square.
Mathematically, this rice equation can be expressed as follows:
Square 1 (1 grain), Square 2 = Square 3 = Square 4 = and so on until the 2nd last and last squares which can be expressed as and . What is more significant is that the amount of rice on the second last square is half the amount on the final square – that’s the power of compounding!
It is unlikely that you will ever experience this kind of return from the market – this sequence, where the amount doubles each year, represents a return of 100% pa. However, it is not unrealistic to receive a return of around 15% pa from equities* and in this case, the capital would double every 4.8 years. There is a useful formula, called the rule of 72, which can be used. By using the factors of 72 one can determine the rate of return or the time taken for that return. For example:
- 9*8 = 72 – in this example, a return of 9% pa means that your funds will double every 8 years. Or if inflation is 8% pa, the value of your funds will halve every 9 years.
- Similarly, at 12% pa, funds will double every 6 years, or at 15% pa this will take 4.8 years.
Perhaps another way of illustrating compounding and its powerful force over time is the following example. It concerns two 25 year old friends. Both want to save money, but while one of them starts immediately, the other decides to wait a bit, choosing rather to spend his surplus cash on “living the good life” and deferring saving to 5 years in the future. In the example, friend A starts by saving R1000 per year for 5 years and then never saves another thing until he turns 65. Friend B, however, enjoys life for 5 years and then starts saving R1000 per year for the next 35 years in order to try to catch up the years he missed.
The picture below says it all…
The lessons are many:
- The old saying may be trite but it is true: it is time in the market (not timing the market) that counts. The earlier you start saving, the less you need to save and the better you will be in the end.
- Compounding is incredibly powerful but it requires time in order for it to work for you – each successive “time period” results in a doubling of your fund value.
- Even though you might be young, you can’t afford to be reckless with your money, thinking that you can make it up if you lose it all. You can’t claw back the years you lose!
- You don’t need a big amount to start saving…there are some funds that will accept debit orders of R100 pm and many that will take from R200 pm. Just start!
Note: it is reasonable to expect real returns of 7-9% pa from equity markets over time – where inflation is 6% pa, 15% returns would reflect the upper expectation.