Being one of the greatest thinkers in human history, Albert Einstein’s name was often attributed to popular quotes.
“Compound interest is the eighth wonder of the world.” is one of them.
While there is no clear evidence to support its authenticity, we can agree that compound interest is an effective tool to grow our wealth.
The Rule of 72 (72 / interest rate) is a simple mathematical tool to estimate the time required for an investment to double at a given interest rate, compounded annually.
A difference of one to two percent can make a substantial difference to the compounding effect over the long term.
For example, the latest average ten-year return of Singapore Savings Bond (SSB) rate is 2.77%.
Hence, an investment of $20,000 in SSB would require 26 years (72/2.77) for it to become $40,000. This is assuming we can get similar interest ten years later.
On the other hand, the average current dividend yield of Singapore banks and well managed S-REITs is more than 5%.
The same investment of $20,000 would require less than 14 years to double. Of course, the assumption in this case is the banks and REITs can maintain their dividends.
Extending the calculation, an annual return of 8% would require just nine years to double, while a 12% return would require only six years.
It is not just about reducing the number of years to double the investment amount. The real magic of compounding comes from giving it time to work.
Have you played the popular puzzle game 2048?
Every merging of the two same-number tiles produce a new tile with a number that is double of original tile.
For example, merging two tiles of “2” produces one tile of “4” and merging two tiles of “4” produces one tile of “8”, and so on. Hence, one can get the tile “2048” after ten merges.
Transfer that idea to wealth growing. Due to compounding, which follows a geometric progression, doubling your initial investment three times can result in an eightfold increase!
Hence, an annual average compounded return of 12% on the $20,000 initial investment would give you nearly $160,000 after 18 years.
Does it really work in the real world?
The image illustrates the growth of my investment over the past two decades. Notably, by the end of the 18th year, it had increased by 14 times from my initial investment at age 30.
I’ll discuss the significance of year 18 in more details later.
This demonstrates the potential of equity investing as a wealth-building strategy.
To be clear, the portfolio exclusively consists of stocks, and does not include more complex investments like leveraged options and cryptocurrencies.
While the underlying Mathematics works, there are important nuances to consider along the way.
It’s not easy to achieve 12% annual return
Given recent market performance, a 12% annual return might seem modest.
Year-to-date (YTD), Nvidia Corp (NASDAQ: NVDA) surged 140% and even SPDR S&P 500 ETF (NYSE: SPY) would have yielded 18% YTD. On the local front, DBS Group (SGX: D05) has returned 24% YTD.
However, to achieve a 12% annual returns consistently over the long-term is no easy feat.
For instance, the 10.4% annualised return of SPY since 1993 is lower than its recent times’ return.
The SPDR Straits Times Index ETF (SGX: ES3), with a 6.6% annualised return since 2002, further underscores the challenges of achieving consistent high returns over the long-term.
Growth is not linear – expect volatility along the journey
The equity market is inherently volatile. Stock prices don’t always rise steadily, and there will be years when investment amounts decline.
As you can see from my experience, over the past twenty years, I’ve encountered five years of losses.
However, if you’re an optimist like me, you’ll note that this implies fifteen years of gains.
Capital injection to the rescue
If it sounds tough, it is.
Here’s the good news though – investing in equities is a long-term endeavour.
You don’t invest only once at the beginning. You can always add to your portfolio, especially during market downturns.
What does that mean?
It is likely that you just need a high single-digit compounded return to build substantial wealth.
Naturally, if you can achieve double-digit returns, that’s ideal.
For further clarity, you don’t need to be a high-income earner nor an extreme saver to grow wealth. I definitely wasn’t.
While I believed in saving for the future, I also wanted to savour the experiences that define my younger years.
Hence, although capital injections provided a boost, the compounding of the return did the heavy lifting behind my wealth growth.
Withdrawing from investment portfolio slows the compounding
It may seem obvious, but given my recent experience, I wanted to highlight that withdrawing from an investment portfolio can slow down compounding.
Since leaving my regular job in early 2023, I’ve needed to maintain a cash reserve and make withdrawals from my investment portfolio.
Hence, I chose year 18 as a reference point as the recent data doesn’t fully showcase the compounding impact.
The image below provides an estimate of what my investment’s growth would look like without these withdrawals.
Despite the substantial decline in my investments, I don’t regret embarking on this new journey.
Money is an enabler of life experiences. For me that is. At this point in my life, I prioritise living my life authentically over accumulating wealth.
Compounding’s magic lies in your ability to increase rate of return and letting time work its magic.
Long-term equity investing is a proven path to wealth growth.
This doesn’t mean I’m against lower-interest assets. They serve different purposes and have a place in our asset allocation.
However, substantial wealth growth often requires calculated risks and equity investments.
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