Compound Interest 1 – Superannuation

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Albert Einstein was asked, “What is the most powerful force in the universe?” and famously answered, “Compound interest.”  I heard an interesting suggestion on the radio the other day.  It was that lactose tolerance evolved over 6,000–7,000 years in Europe, with perhaps a 5% enhancement in survival rates for people born with this trait.

That doesn’t sound like much, but over that period there have been about 260 generations.  The cumulative effect of a 5% advantage in each generation is 1.05^260 which is 323,000.  In other words, one could expect lactose-tolerant people to outnumber their lactose-intolerant peers by 323,000 to 1.

What is the effect of squeezing a slightly higher rate of return from one’s savings?  It’s not as dramatic, of course, but assume that a youngster joins the workforce at age 22 and works to age 67, saving $5,000 per year.  With an average annual return of 5% he or she would retire with a lump sum of $820,000.  But if that return were 6%, the lump sum would be $1.1 million.  One-third more.  Half-a-house more.  Enough to pay off a student loan for a medical degree and have some change.

How hard is it to squeeze an extra 1 percentage point annually from your super fund?  Well, bear in mind that it’s the net return to you that matters.  If you’re paying someone else to manage it, start by checking how much they’re charging you for that service.  If it’s more than 1% you can probably find someone else who’ll do just as good a job for less.  Read the fine print to see if you’re paying two fees: one to manage the fund and one for ‘advice’.  That happened to someone I know.

And how much risk are you willing to bear?  Over the long term, equities tend to perform better than bonds.  For one thing owning part of a capital asset gives you some protection against inflation.  For another, you might lose 100% of your money in a risky investment that goes bad, but you can’t lose more than 100%.  On the other hand if a risky investment succeeds there’s no limit to your possible profits.  Over a lifetime, the big gains are likely to outweigh the total losses.  Not certain, but likely.

Disclaimer:  I am not a financial planner, financial advisor, banker or anyone else with special insight; and I’m not trying to sell you a financial product.  I manage my own investments (with advice that I trust) and I suffered in the dot.com bust and the GFC like everyone else.  But I’ve recovered, just about, emotionally and financially. 

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