Finance professionals often talk about the importance of compounding, but what exactly is compounding? To become a master violin player requires time and deliberate practice. This was the finding of a study of violin students in Berlin, in a paper “The Role of Deliberate Practice in the Acquisition of Expert Performance” by Anders Ericsson. He found that those who began in childhood and negotiated motivational and external constraints, succeeded. Those who had years of deliberate practice became expert performers. Many characteristics once believed to reflect innate talent are actually the result of intense practice extended for a minimum of ten years. So too with compounding.
Source: The Role of Deliberate Practice in the Acquisition of Expert Performance
Compounding is a financial phenomenon that makes time work in your favour. It's what happens when your investment earnings are added to your initial investment, forming a larger base on which earnings may accumulate. And as your investment base increases, it has the potential to grow faster.
As with violin playing, the time invested matters and starting young makes a considerable difference.
Take two university graduates: Graduate 1 started saving at 21 and invested R10 000 a year, then stopped contributing at 30, but left the investment untouched until the age of 65. In that 9-year period, he contributed R90 000. Graduate 2 started saving at 30, then kept contributing R10 000 a year until age 65, contributing a total of R350 000 during that period. If they both earn an average rate of 10% during the period.
- Starts investing at 21
- Invests R10 000 a year
- Contributes actively for 9 years, then stops
- Total invested R90 000
- Withdraws at 65
- Time invested 44 years
- Average return 10%
Savings at 65 = R4.198 million
- Starts investing at 30
- Invests R10 000 a year
- Contributes actively for 35 years
- Total invested R350 000
- Withdraws at 65
- Time invested 35 years
- Average return 10%
Savings at 65 = R2.981 million
To catch up to Graduate 1, Graduate 2 would have to increase his contributions by 40%.
Deliberate practice and negotiating motivational and external constraints make the difference. The early years of saving can feel frustrating, as the results are pedestrian. There is a temptation to withdraw, buy cars or seek “racier” investments, especially with retirement savings. However, like violin playing, the true mastery happens by staying the course, after about 10 years.
Let’s say you invest R1 000 a month at a 10% return. Your jump from R0 to R200 000 takes 33% of the total time. Moving from R400 000 to R600 000 takes 11% of the total time and moving from R1 800 000 to R2 million takes 3.6% of the total time.
We can enhance compounding by making it tax efficient. With both tax-free savings and retirement annuities, the time benefit is amplified by the tax efficiency, making them good vehicles for long-term savings.
For example, if you saved R36 000 a year for your child in a tax-free savings account, up to the R500 000 lifetime maximum contribution by age 18 - and the funds remained there until retirement - your child could potentially retire on just these proceeds.
Many characteristics once believed to reflect innate talent are actually the result of intense practice extended for a minimum of ten years. Both Warren Buffet, a professional investor, and the late Ronald Read, a retired gas station attendant and janitor from Vermont, created millions from investing early and staying invested.
Musical and money mastery both require time and deliberate practice. What money practice can you start today?
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