Finance Fridays: Make your money work for you - The wonder of compound interest

November 20, 2015, 11:43am

By Dantagos Jimmy-Melani, Ndapunikwa Investments

Many of us often allow banks, financial advisors, relatives or even romantic partners direct our hard-earned money in ways that we don't necessarily want or understand. No one should be in a better position than you are to know what is best for you when it comes to your own money. Or at least, that should be the case, after you are done reading this article.

First and foremost, it should be emphasized, that taking control of your personal finances requires effort on your part. The initial step usually involves identifying and cutting down on any unnecessary expenditure, which you can then redirect towards a well-researched and fully understood, savings and investment plan. In this regard, there is no amount too small. If you can only afford to put away N$50 a month, it is still a noble and worthwhile starting point.

When it comes to investing the money you have not spent at the end of the month, it's actually pretty simple to understand: investing means putting your money to work for you. Growing up, most of us were taught that you can earn an income only by getting a job and working.

There's one big problem with this though; if you want more money, you have to work more hours. There is, however, a limit to how many hours a day one can work, not to mention that the labour law, health and safety standards dictate that you take the necessary time off from your place of employment, to enjoy the money you have worked so hard for.

Therefore, since you can't create a duplicate of yourself to increase your working time, you need to send an extension of yourself - your money - to work for you.

The key to understanding investments is understanding the concept of “compound interest”. The wonder of compounding (sometimes called "compound interest") transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset’s reinvested earnings.

To work, it requires two things: Firstly, the re-investment of earnings, and second, time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.

To demonstrate, let's look at an example:

If you invest N$10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now let's say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year. Because you reinvested that N$600, it works together with the original investment, earning you N$636, which is N$36 more than the previous year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest.

Even though all investors are trying to make money, each one comes from a diverse background and has different needs. It follows that specific investment vehicles and methods are suitable for certain types of investors. Although there are many factors that determine which path is optimal for an investor, we'll look at three main categories, depicting investment objectives, and the investor’s personality.

Generally speaking, investors have a few factors to consider when looking for the right place to park their money. Safety of capital, current income, and capital appreciation (meaning the increase in the value of the investment which takes place between the time an investment is entered into and subsequently terminated or liquidated for cash), are factors that should influence an investment decision and will depend on a person's age, stage or position in life, and personal circumstances.

As a general rule, the shorter your time horizon, the more conservative you should be. For instance, if you are investing primarily for retirement and you are still in your 20s you can take more risk than someone who is in their fifties and very close to retirement. An investor's financial position will also affect his or her objectives. A multi-millionaire is obviously going to have much different goals than a newly married couple just starting out.

These are some of the key principals to consider, together with an understanding of the power and wonder of compounding interest, before making an investment decision. So do your research, cut down on your expenses, and get started on saving and investing today!

Investments photo: Business Review (Romania)
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