The Awesome Power of Compounding Interest

Imagine if you were to earn an average of $3000 a month for your entire working life of 40 years. If you were to just invest 10% of your income a month (in this case, it will be $300) into a mutual fund and allow it to compound at 10%, how much would it grow to?

Using a financial calculator, you will see that $300 a month invested at 10% will grow to $1.8 million! And that just from investing $300. If you could invest $1000 a month at 10%, it will grow to nearly $6 million!!

How is this possible? How do small amount of money grow into huge sum? This is the result of the power of compounding. I’m sure you have heard of this term before (I mentioned this in my previous newsletter) but what does it really mean to you?

Compound return is achieved when you invest a sum of money at a particular rate of return. Instead of taking out the interest earned after a year, you add it back to the principal sum and reinvest this larger sum. So the next year, the rate of return is on a larger principal sum. This continues until the returns a year become greater and greater!

For example, say you invested $100 into a fund that gave you an annual return of 20%. At the end of one year, you would have $120. Instead of taking out the RM20 profit, you leave it inside for another year at the same 20%. At the end of the 2nd year, your investment would grow to $144. The next year, it will grow to $172.80 and on the 4th year, it will grow to $207.36!

In less than 4 years, your initial investment has doubled in value!

How long it will take your money to double in value?

Albert Einstein, the greatest genius of our time once remarked that compound interest was the greatest mathematical discovery ever made! He came up with a formula called the Rule of 72. It states that if you take 72 and divided it by the annual percentage return, it will give you the number of years your investment would double!

For example, in the previous case, the percentage return was 20%. So if you take 72 ÷ 20 = 3.6 years you will see your investment of RM100 double to RM200 in 3.6 years.

The power of compounding was Warren Buffet’s secret weapon in creating the second biggest fortune in the world, purely by investing in US stocks. Warren achieved an average annual return of 24.7% for 49 years! This means that his money doubled every 2.9 years (72 ÷ 24.7 ). He turned an investment of $ 100,000 in 1956 into $4,200,000,000 ($4.2 billion) today.

Would you bet 10 cent on a game of golf?

Let me give you another example to further illustrate the power of compounding. Let’s say we played a game of golf and we made a friendly bet of 10-cent on the first hole, with the bet doubling on each hole. Would you take on this bet? Now, if you were familiar with the game of golf, you would know that there are only 18 holes, so how much can the bet be on the 18th hole?

Well, let’s see how the bet increases on the first 9 holes:

At the 9th hole, the bet is $25.60. We are ready half way there, so how much could it be on the 18th hole? $100? $300? $500? Let’s go on…

As you can see on the 18th hole, the bets becomes a whopping $13,107! When given enough time, the power of compounding can turn very small amounts of money into huge sums.

A more important lesson I want to illustrate is that initially, the money grow very slowly. Even at the halfway mark, it is only $25.60. However, the moment it reaches a critical point, the growth becomes exponential! In fact, between Hole 15 and Hole 18, within just 3 holes. It grows from $1,638 to $13,107, a $11,469 difference!

What does this mean to you? You see when you start your investment program of say $200 a month, initially the growth is extremely slow. However, once it hits a certain period of time, the growth explodes exponentially! The trouble with most people is that when they see the slow growth during the first few years, they lose patience and abandon their investment plan. So you must have the patience to wait for the power of compounding to work for you and reward you with millions.

An example of what the graph looks like is shown below. Once again, notice how the phenomenal power of compounding starts off very slowly but starts to grow exponentially once it hits a certain critical point. The chart below shows you how different amounts of investments grow under different rates of return.

(Click to enlarge)

Awesome? Let's start invest and accumulate your wealth now!!

DAVE

How to turn your EPF into a cash generating machine

Before we explore the secret of turning your EPF saving into a powerful cash generating machine, let's understand your EPF in more details.

As you are aware, EPF contributions made by an employee and by his or her employer on behalf of the employee are paid into the employee’s EPF account. Each account comprises two sub-accounts:

• Account 1 comprises savings for retirement at age 55. 70% of contributions are credited to this account.

• Account 2 comprises savings that can be withdrawn for the purchase of a house, mortgage repayments relating to a housing loan, education, medical expenses and/or pre-retirement withdrawal age at age 50. 30% of contributions are credited to Account 2.

Since 1996, under certain conditions, a member is entitled to make transfer from his or her Account 1 balance to an approved unit trust scheme. The latest revision of the withdrawal policy has been enforced on 1st Feb 2008.

The EPF will process a request to transfer an amount from a member’s Account 1 to approved unit trust scheme if:

• The Account 1 is not less than predefined basic saving according to age group (Table 1).


• The member is less than 55 years old.


• An account in the approved unit trust scheme has been opened which the transfer can be processed.


• No transfer has been made in the previous 3 months from the EPF Member’s Investment Scheme.


• The amount eligible for transfer is not less than RM1,000


• The amount to be transferred is not more than 20% of the Account 1 balance remaining after deducting the predefined basic saving (subject to a minimum of RM1,000)
  

Table 1. Account 1 Total Basic Saving

Below are examples in determining whether an account holder is qualify for a withdrawal

After fulfilling all the conditions above, you can start turning your EPF saving into a powerful money making machine for your retirement. Let’s look at the simulation below.

You are 28 year old, being paid for RM3,500 monthly of your job currently and has an accumulative EPF account 1 saving of RM30,000. Assuming that you start investing your EPF saving every year into a unit trust scheme which offered a moderate annual return of 10% for the next 27 years, you will see the result of the simulation below.

(Click picture to enlarge)

You will have an extra of RM 527,120 in your account when you retire at the age of 55! Thanks to the wonder of compounding interest, all this will be achieved passively by just investing 20% of your account 1 balance into a unit trust scheme annually. In fact, you can do this in a much frequent basis which is every 3 months as long as the 20% of your account 1 balance is more than RM1,000.

Let’s look at another scenario which demonstrates a more robust return in a longer period. Assuming you start investing in a unit trust scheme at the age of 25 and the annual return of the UTS is 12.5%.



(Click picture to enlarge)

It is almost 3 million!! A double of the normal EPF saving! Is this real? By a difference of 3 years and 2% of annual return? Well, figures don’t lie, as long as the projection is accurate and you start investing early.

How about if the projection is not accurate and you only able to achieve 8% return every year? Well, let’s look at the simulation again.

(Click picture to enlarge)

Well, you still get an extra of RM 264,307. Not too bad, right?

The learning is simple. By investing your EPF saving into unit trust, you are going to expect an above average return in long run. If you start investing early, the possible return will be very much higher as the effect of compounding interest taken place. Of cause, you will need to invest in good unit trust schemes which managed by professional fund managers. So, what are you waiting for? Let’s kick start and move towards your ultimate dream of financial freedom. Call me for more information.

Bonus gift – download the EPF calculator and run your own simulation! You will know what you are going to get in the future.

Dave