By earning interest on top of interest, you can build your wealth exponentially, which is why time is one of the most important factors in investing. The longer this compounding effect has to work, the more significant it becomes.
There is a popular urban legend that Albert Einstein called compound interest the “eighth wonder of the world”. In reality, this quote was first attributed to the great mathematician only 30 years after his death, so it is unlikely he ever said it. But that does not mean that the sentiment is not true.
By earning interest on top of interest, you can build your wealth exponentially, which is why time is one of the most important factors in investing. The longer this compounding effect has to work, the more significant it becomes.
However, while compounding can obviously work in your favour as an investor, the ugly reality is that it can also work against you because of the fees you pay.
Effectively, fees reduce your returns. And over time, higher fees reduce the rewards of compounding in the same way that interest does.
As National Treasury noted in a 2013 paper on charges in South African retirement funds, if a saver can reduce their fees by 2% every year, their retirement pot will be 60% bigger at the end of 40 years.
“In real life, this means that if your annual management or administration fees are 2% lower, you can retire with 60% more in benefits,” explains Sygnia Head of Retail, Trisha Jorge. “Instead of R1 million, you will retire with R1.6 million.”
Even saving 1% a year would make your savings worth 25% more over 40 years – and Jorge says this is not difficult to achieve.
“Unit trusts range in price from 0.40% per annum to over 3% per annum,” she says. “In practice, the 3% unit trust must outperform the 0.4% unit trust by 2.6% per annum to deliver the same after-fees return to the investor – which is highly unlikely. Even a 1% per annum out-performance is a stretch. So it really is foolish to pay more on what is at best a gamble on out-performance.”
As an investor, you should therefore look carefully at the total expense ratio (TER) on your chosen fund’s fact sheet. If it is more than 1.5%, Jorge believes you are overpaying, and you should be able to save as much as 1% a year by finding a much cheaper product with the same risk profile.
Compounded over time, those benefits are significant.