It’s often said that starting out early on one’s investing journey will deliver higher returns over the longer term.
To use an old sharemarket adage, time in the market (taking a long-term approach) will invariably win over trying to time the market (buying and selling around short-term events) when it comes to achieving investment success.
History shows us that investment markets have delivered strong growth over the longer term. When combined with the power of compounding, and by reinvesting dividends and making additional contributions, even a low initial balance will grow substantially over time.
But how do the numbers really stack up, and do a few years here and there really matter in the grander scheme of things?
Let’s take two hypothetical individuals the same age, “Sally” and “John”. By putting away savings from their part-time jobs, and with a bit of help from their parents, each has managed to accumulate $5,000.
Sally decides to begin investing at age 20 by placing her $5,000 into a managed fund that invests in the top 300 Australian shares. The fund has achieved an average annual return after fees of more than 8% over more than two decades.
The share dividends from the companies in the fund are paid out to investors as distributions on a quarterly basis. But, rather than taking the distributions as cash payments, Sally has chosen to automatically reinvest the proceeds to buy more units in the managed fund.
She has also decided to make regular additional investments into the fund from her ongoing job earnings, equating to $20 per week ($1,040 per year).
John has exactly the same aspirations as Sally, to build wealth and financial security over the long term, and follows the same strategy. The only difference is that, instead of starting at 20, he invests his $5,000 when he’s 25.
Comparing the pair – will the gap make much difference?
After five years of investing and making additional contributions, Sally has built up a balance of $13,448. John is just starting out, and still has $5,000.
The five-year investment gap continues to widen over time, because Sally has had the benefit of a longer period of compounding returns and making additional contributions.
After 10 years, at age 30, Sally’s investment balance has reached $25,861. John, also 30, has reached the $13,448 mark.
After 20 years, at age 40, Sally has $70,897. John has $44,099 – almost $27,000 less.
When they reach age 50, their respective balances are $168,128 and $110,273.
And, by age 65, the gap has widened to closer to $200,000. Sally has accumulated $561,568, while John has a balance of $378,041.
It’s important to remember that the numbers above are based on investing the same amount in the same product, achieving an average annual return after fees above 8% (which is actually what the Australian sharemarket has delivered for more than two decades), and making the same additional contributions.
Increasing contributions over time
The numbers get even more interesting, even when using the same initial investment amount, following a more realistic pattern where each investor chooses to increase their contributions over time as they get older, because they are earning higher wages.
To keep things simple, let’s say Sally and John decide to lift their contributions by the same amounts over time, after three years, then again in another seven years, and then 10 years later.
So, at age 23, Sally increases her contributions from $20 per week to $40. At age 30 she lifts her contributions to $50 per week, and by age 40 she can afford to invest $100 per week ($5,200 per year).
John follows the same strategy but, having started at age 25, his contributions are instead lifted when he turns 28, 35 and 45.
Here’s how the numbers come out.
By age 25, Sally has a balance of $16,824. John is only just starting off, so his balance is still $5,000.
By 30, Sally has a balance of $37,443 versus the $16,824 John has reached at the same age.
At age 40, the respective balances are $121,101 and $70,269, but the benefits of compounding over time really come to the fore further down the track when both individuals may be considering retirement.
At age 63, Sally has amassed more than $1 million in savings, while John has $678,664.
When they both reach 65, they have respective balances of $1.21 million and $802,409 – a gap of more than $400,000.
The power of compounding
Taking that to another level, and keeping in mind the increased contributions strategy over time in this example, what would happen if either had simply invested $5,000 at the start and made no additional investments, instead relying on the long-term growth from his base investment amount?
At age 65, over a 45-year period, Sally’s initial investment would have grown to $159,602. John’s would be $108,623.
But that’s substantially lower than either could have achieved by making additional contributions.
The numbers are compelling. Starting on one’s investment journey at a younger age makes a huge difference over time.
So does making additional investment contributions on a regular and structured basis, because the overall investment earnings including reinvested distributions will be calculated on a progressively higher balance. That’s the power of compounding.
About Tony Kaye
Tony Kaye is Senior Personal Finance Writer at Vanguard. He was a former manager at Standard & Poor’s Ratings and has a regular column in the Australian’s Wealth section. Tony has also written for newspapers nationally; The Telegraph, The Herald-Sun, The Advertiser, The Courier Mail, NT News, Canberra Times and more. He has a Bachelor of Arts and Journalism at Curtin University and Public Relations at RMIT University.
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Main image source: r.classen (Shutterstock)