Looking for growth? You’d be a fool to ignore income. Albert Einstein who called compound interest the eighth wonder of the world – famed to have said: “He who understands it, earns it ... he who doesn't ... pays it”.
Einstein is not the only high profile fan of compound interest. Warren Buffett, the sage of Omaha himself described investing to Forbes as “forgoing consumption now in order to have the ability to consume more at a later date”.
Compounding interest is when you pay dividends back into the capital sum, allowing that capital sum to grow and in turn the dividends will grow too. These larger dividend payments are invested back in to the savings pool, and the process repeats itself. Accumulating dividend payments can help to make even the most meagre of saving pots matter.
Compound interest decrees that early gains cannot ever be caught up at a later date – no matter how small. A deposit of Rs 10,000 invested for three years, earning a rate of 5% without compound interest would yield three payments of Rs 500 – Rs 1,500 plus the initial deposit of Rs 10,000, totalling Rs 11,500. Using the compound interest calculation, the savings would in grow in value to Rs 11,576 over three years, an extra Rs 76. And over a longer time horizon that extra Rs 76 would grow to much more.
In India, the PPF is a good example of how interest earned is compounded and the initial investment grows to a sizeable corpus over the years. If you invest Rs 1 lakh in a PPF account every year for 15 years, your investment of Rs 15 lakh would accumulate to over Rs 30 lakh over this time frame, simply because the interest earned is compounded annually.
The power of compound interest also explains why if you have a longer time horizon it pays to take a more risky stance. High yield bonds reward investors for taking on risk with a higher rate of income. Over time – even if the value of your investment falls – 7% annual income can be compounded to result in considerable growth.
Equity markets are one area where risk can be rewarded. Let’s look at an emerging market fund. If you had invested £10,000 in Newton Asian at the start of 2006, when Jason Pidcock took over management of the fund, it would be worth £26,467 - excluding reinvested dividends this would fall to £18,613. During that time £5,300 would have been paid out in dividends, the difference of £2,554 comes from the effects of compound interest. That is a boost of almost 10% of the total.
“Income investing is the best approach for investors looking to get rich slowly. Equity income offers a combination of attractive income, rising yields and capital growth,” said Adrian Lowcock of Hargreaves Lansdown. “Investors who don’t need the income can reinvest it to get additional benefit from growing dividends. Equity income in particular helps investors keep their wealth growing ahead of inflation.”
This article from Morningstar.co.uk has been written by Emma Wall, U.K. website editor. It has been edited to suit an Indian audience.
