QMy mother tells me that I need to save money every month for my future. As a single mother, she has done very well financially, but admits that if she could start all over again, she would have started saving much earlier and saving much more. I have decades ahead of me before I even think about retirement, but she says I need all that time for my money to grow. What is all this talk about capitalization?
AYour mom is right! (Again, don’t moms always get it right?) When you start setting aside funds for your retirement, one of the best financial strategies you can have in your corner is the power of compounding.
Compounding means earning an additional return on your initial investment returns. In other words, not only does the money you invest make money, but those returns also make extra money.
Professor, physicist, mathematician and Nobel laureate Albert Einstein said, “Compound interest is the eighth wonder of the world. Whoever understands it, wins it. Whoever doesn’t, pays.
An ancient Hindu legend about the origins of chess can help us understand what Einstein meant about composition.
A wise man invented a new game for the Maharajah, the emperor who ruled the Indus Valley in northern India in the 6th century. This strategy game, called chaturanga, was played on a 64-square board, similar to modern chess.
Delighted with this new invention for his entertainment, the Maharaja granted the sage a single wish. And because he was such a wise man, he asked for a single grain of wheat on the first square, two grains of wheat on the second square, four on the third, eight on the fourth, and so on through the tray, doubling the grains. wheat on each successive square.
If you do the math, you will come to understand exactly what the Maharaja realized: that he owed the sage more grains of wheat than existed in the whole world! This problem was easily resolved as the Maharaja immediately ordered the execution of the sage. (I guess the sage was a bit too wise!)
Certainly, the sage was earning a hundred percent rate of return on each sequential square – far greater than any investment would normally yield; however, the principle of composition remains the same, regardless of the numbers. Earning extra yield on your initial investment returns can really add up in the long run.
Let’s explore an example of an investment held in your RRSP (registered retirement savings plan) or your TFSA (tax-free savings account). This allows us to eliminate any tax consequences, as investments grow on a tax-free basis in both types of accounts.
Assume your investment earns a 5% rate of return and you contribute $10,000 to the account each year for the next 25 years. If you retire at this time, your investment will be worth $500,000. Your compounding money on itself really has an impact over time. If you had 35 years of savings and compounding ahead of you — instead of just 25 — the investment would be worth $946,000. What a difference a longer delay makes!
And if you could obtain a compound capital of 8% over 35 years, instead of only 5%, your investment would be worth the tidy sum of $1,850,000! The composition is truly a wonder of the world! (And your mother, like Albert Einstein, knew compounding returns can do wonders for your retirement planning.)
The two most important factors in the composition of investments are the length of your time horizon and your rate of return. Using both to your advantage is achievable – without the risk of execution by a Maharajah!