Investing

Q16: What do we want? When do we want it?

For some people the chant goes “I want money and I want it now“, but investing is a long-term pursuit

There are many things in life that can be hurried; a 100m sprint, for example, or ripping off a band-aid. Other things are of longer duration, such as a marathon run; good wine takes time to develop and mature and a slow roasted lamb shoulder can be in the oven for up to eight hours. It took Michelangelo six years to fresco the ceiling of the Sistine Chapel. Conclusion: the best things in life take time.

And so it is with investing.

sistine

Michelangelo’s Sistine Chapel: Not a rushed job.

But investing can take a whole lot longer than painting the roof of a chapel. In fact, most people save their whole lives just so they can have a comfortable retirement. Strangely, when you’re young and you project forward to your autumn years it seems like forever away; then when you are in retirement you look back on your life and wonder “where did those years go?”. Because of this discordant time perception it’s important to take action when you’re young so you use time to your advantage, capitalising on the extremely powerful effects of compound interest.

In the early years, investing can seem like it’s not getting you anywhere. You drip-feed a few hundred dollars every so often into an account and watch it go pretty much nowhere for a few years. You may wonder if there’s any point in continuing. In a superannuation investment a meagre 9.5% of your monthly salary gets paid into your fund twelve times a year and after a year or two there’s not an impressive amount in there. Your earnings haven’t really helped the balance and if you had to retire today you’d hardly have enough for a loaf of bread and a carton of milk.

Fortunately you’re unlikely to retire at 25 years old. Time, as they say, is on your side. Let’s look at a chart of some savings. This chart assumes that you can save $500 a month, every month ($6,000 a year is probably close to a young worker’s superannuation payment), and that you can earn 5% annually, paid monthly. [5% is a conservative estimate of long-term earnings for a well-diversified, multi-asset portfolio of investments]. See Chart 1, below, which shows the cumulative value of all the payments that are made to your super fund, the interest earnings and the total value of your investment over 50 years.

total_value_annuity

Chart 1: Saving $500 per month. Earning 5% per annum

For the first few years, it’s pretty uninspiring. Your total investment value barely exceeds the amount you’ve contributed. But just before the ten year mark things start to get interesting (excuse the pun). The interest you earn starts to contribute more and more to your total investment. You’re still salting away your $500 every month but the total amount is beginning to earn a decent amount of interest each month and the compounding effect of interest-on-interest makes your investment amount rise, and it will rise at an accelerating rate.

After 25 years you’ve put in $150,000 but the interest you’ve earned has doubled that amount, so your balance is now around $300,000. That’s an extra $150,000 you’ve now got that you earned for free. Things are starting to rev up. From 25 years onwards the amount you’ve earned in interest is greater than the amount you have put in, and if you keep on saving $500 a month and earning 5%, always will be. And the longer you keep saving the greater the interest earnings will be. You can see from the chart that the interest earnings (and therefore your investment balance) increase at an increasing rate. After 50 years you’ve put in $300,000 but interest has added over $1,000,000 more. This is called exponential growth and it’s the secret to the power of compound interest.

annuity_contrib

Chart 2: How interest payments stack up

Chart 2, above gives another illuminating view of how interest can work for you over a long period of time. Using the same $500 per month/5% interest scenario as before, this chart shows that, while your monthly contribution stays the same, the interest that you earn each month gets higher and higher. After only 14 years of saving, the amount of interest you earn per month equals the amount you’re putting in: after 14 years interest payments are doubling your contribution. You’re getting a leg-up for free — it’s like you’re putting in twice the payment every month. Things only get better after that. At 32 years interest is four times your contribution. At 44 years it’s giving you eight times your contribution and at 47 years interest earnings are ten times your monthly contribution.

On these estimates a meagre $500 per month contribution to superannuation would accumulate to $763,000 after 40 years, $1,013,000 after 45 years and a monstrous $1,344,000 after 45 years. Saving more each month, by contributing extra or from getting a pay rise will substantially improve the outcome.

timeclock

Time. Your friend.

There is a small catch, of course, and that’s the theme of today’s post: you need to allow time to take its course and to invest in a well-diversified portfolio with allocations to multiple asset classes which will reduce the risk of substantial losses. An all-too-familiar situation is where investors chase high returns from high-risk investments (often placing a large proportion of their savings in one investment) and end up losing a big chunk of their money. Get-rich-quick is the enemy of wealth accumulation which, to increase the chances of success, requires time and patience.

The easy part is that we all have the time. There’s not a lot we can do to speed up the clock. But we do have control over our ability to save and, more importantly, we can control our patience. There’s no need to rush things. Time and compounding can, as you saw above, do the work for you. Successful investors know that the get-rich-slow method is a well-trodden path to achieving investment objectives.

Next time you buy a nice bottle of wine and put it in the cellar for the future, remind yourself that the contents will take time to mature — the longer, the better — and that the end result, when the cork gives that happy “pop” sound, will be worth the wait. Your investments are more important than a bottle of wine, so treat your money with great care.

Michelangelo didn’t rush the Sistine Chapel. He knew that the best result required time and patience. And if you’ve seen that ceiling you’ll know what a great result he achieved.

 

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