The power of starting to save early and compound interest

In South Africa, Youth Day (celebrated annually on 16 June) pays homage to the power and potential of our country’s youth. This occasion also serves as a great reminder to emphasise the importance of financial literacy and the benefits of saving and investing from an early age. Understanding compound interest and the advantages of early savings can significantly impact an individual’s financial future.

A recent Flux Trend Report*, which interviewed 30 young South Africans under 30, revealed that most are saving money regularly for short-term expenses such as groceries and tech devices, rather than for purchasing homes or retirement. This trend persists despite many expressing a desire to retire early. This highlights the critical need for greater awareness and education on the importance of long-term savings and financial planning.

The importance of longevity planning – we’re living longer

 Today, the average human lifespan has increased significantly due to advancements in healthcare and improved living conditions. While this is undoubtedly a positive development, it also poses unique challenges, particularly regarding financial planning and retirement savings. As individuals now need their assets to last longer, there is an increasing emphasis on the importance of saving early and growing assets throughout one’s working years. After all, money can only be invested if it is saved.

The benefits of starting early

First things first – manage your money, instead of letting your money manage you

By keeping track of your monthly expenses, you can identify what you are spending your hard-earned money on. This could enable you to rectify your unwanted spending patterns and show you where you could save. If you aren’t able to save just yet, your budget could assist you in creating a roadmap and setting goals as to how you could adapt or adjust your lifestyle to be able to save more. One step at a time.

Smaller contributions, bigger impact

When you start saving early, you can make smaller monthly contributions and still reach your financial goals. Smaller contributions ease the burden on your budget. A great way to get started is to start the habit of paying yourself first. In the wise words of investor Warren Buffett “Do not save what is left after spending, but spend what is left after saving”.

An easy way to instil this disciplined approach is to set up a debit order at the beginning of the month to automate your preferred savings amount into the savings vehicle of your choice. Saving early cultivates good financial habits and healthy spending habits. By setting aside money first, you learn to manage what remains, leading to disciplined spending.

The magic of compounding

Albert Einstein famously referred to compound interest as the “eighth wonder of the world,” emphasising its remarkable impact. Essentially, compounding makes your money work harder for you.

Let’s consider what compound interest is using an example. When you plant and water a seed, it sprouts into a fruit-bearing tree. Not only do you get to enjoy the fruit of the tree, but you can also plant the seeds of the fruit, to grow more trees. This analogy illustrates how compound interest works with your money.

When you invest, the interest you earn is added to your original investment, and then you start earning interest on the new, larger amount. Over time, this process of earning interest on both your initial investment and the accumulated interest leads to exponential growth. Given enough time, the value of your investment can grow substantially, with a significant portion of the growth coming from the compounded interest rather than your initial contributions.

As illustrated below, small contributions can have a massive impact when combined with compound interest – even if it might not feel that way in the short term.

In Exhibit 1 below, we compare the investment journey of two investors.

• “Investor 1” at 25-year-old invests R5,000 every year for 10 consecutive years. After age 34, no additional investments are made and the money is left to grow until the investor reaches age 65.
• “Investor 2” at 35-year-old invests R5,000 every year for 30 consecutive years until retiring at age 65.
• In both scenarios we assume an 8% interest rate and a retirement age of 65.
• Interest is compounded annually.

As can be seen below, the individual who started investing at 25 years old and made 10 total payments of R5,000 will end up with approximately R787 176 at age 65. The 35-year-old who made 30 total payments of R5,000 will end up with approximately R616 729 at age 65. This shows us the importance of saving, investing and remaining invested for the long term – even with a small amount.

Exhibit 1 | The power of compound interest on long term savings

Source: Author’s own calculations. Past performance is not a reliable guide to future performance.

Greater risk-taking ability and mitigating market volatility

Young investors can afford to take more risks – not necessarily because they have less financial responsibility, but because they have time on their side. A younger investor has time to weather sticky market conditions and the volatility often accompanied by high-risk investments. Starting to save early gives you more time to weather market ups and downs, thereby reducing the impact of short-term volatility on your long-term retirement savings. Over the long term, markets tend to grow, and by staying invested in a diversified investment strategy, you can benefit from market recoveries and potentially mitigate the impact of market downturns.

Coping with inflation

Inflation erodes the purchasing power of money over time. With longer lifespans, retirees face a greater risk of inflation eating away at their savings. By saving early and consistently growing assets, individuals can better protect themselves against the impact of inflation. Investments in assets that historically outpace inflation, such as equity investments, can act as a hedge against rising prices, ensuring a more secure financial future.

In conclusion

Starting to save early in life is not just about setting aside money; it’s about cultivating healthy long-term saving habits and thereby securing a healthy financial future. Warren Buffett often credits the power of compound interest as the driving force behind his unmatched investment legacy, stating “My life has been a product of compound interest.”

The power of compound interest means that even modest, consistent contributions can grow into substantial savings over time. By taking proactive steps today – whether it is opening a savings account, exploring investment opportunities, or seeking financial advice – you pave the way towards financial independence. Remember, every small step today contributes to a more secure and prosperous tomorrow. Empower yourself by investing in your future now.