Imagine for a moment that you are holding a R1 coin from 1966 in your hand. It’s heavy and feels like money should. Valuable.
Now, what if I asked you if you would rather have that coin in your hand or in the bank since it was minted 52 years ago.
I’ll give you an advantage. This bank charges no fees and pays an annual interest rate of 10% on your money.
Would you rather have had this coin sitting forgotten in a drawer somewhere only to have been discovered now, or sitting in the bank at no cost to you steadily growing in value by 10% a year?
Most people when I ask them the question go: “The bank.”
Like you, they don’t have all the facts.
This R1 coin is not collectible. There are thousands of them. So where is the value? If you took it to the shop and managed to convince the shopkeeper it was legal tender, they would give you goods to the value of 100c in return for the coin. So in real terms, this R1 sitting in your drawer has lost considerable buying power when it was first minted. In terms of buying power, and using SA Reserve Bank inflation data, you would need to spend R82.44 today to get the same goods you would have paid R1 for in 1966.
Still want the money in the bank? Or like most of us, knowing that money loses value over time, just spend it on something frivolous.
What if I told you this coin had an ounce of silver in it? Would that change your mind?
Commodity prices this week have been taking strain, so silver is a little depressed at $15.42/ounce, multiply that by the current exchange rate of R13.25/$ and the coin sitting in your bottom drawer over 52 years has a notional value of R204.31.
Not that you are going to get the full value of the silver, of course, because anyone you sold it to would have to melt it down and there would be a cost involved in extracting the metal. But still. That is the value of the silver, and hence the value of the coin.
You’ve heard of compound interest.
CAGR – compound annual growth rate, according to Wikipedia is: “a useful measure of growth over time periods. It can be thought of as the growth rate that gets you from the initial investment value to the ending investment value if you assume the investment has been compounding over the time period.” Let me explain.
You put R1 into this free bank account and at the end of year one you have R1.10. You then earn interest on R1.10 not the original R1, so that by the time you get to year 5, your R1 is worth R1.65. You have 65% more than your original investment thanks to the power of compounding. You get interest not only on your investment but also on the interest you have accumulated. That’s pretty nifty.
So? The coin or the bank account?
By the time you get to year 52, you will be earning R16.82 in interest alone on your investment, which thanks to your friendly bank manager charging you nothing to keep it there, would have grown to the princely sum of R177.41.
The coin in your bottom drawer is worth more.
Realistically though, would you have got a 10% rate?. Sure, there have been times in South Africa where interest rates went as high as 24%, but depositors always get less than borrowers.
So lets assume you got an annual compound growth rate of just 7.5%. It’s 25% less interest than you would have received earning 10%, so therefore you would get 25% less as a return, right?
You need to start concentrating now. Sorry. But it’s important.
Remember, in year 5 at 10% you had R1.65. Now at 7.5% you are earning 25% less interest. With a return of 7.5% you have just R1.45. Not significant? It’s only an 11% difference.
No big deal? Wrong.
Every month you earn even a tiny bit less interest or get even slightly less growth or pay a slightly higher fee for your investment, it diminishes your final return.
By the time you have left that money for 52 years, instead of getting R177.41 thanks to a 10% return, you are getting just R48.81. Considering that it would cost you R82.44 today to buy what R1 would have bought you in 1966, leaving your money in the bank even at 7.5% means you are 40% poorer today than you were 52 years ago.
By giving up 2.5% in interest you are getting a return worth just over a quarter of what you would have received had you received the higher rate.
Just to illustrate how important every percentage point return is. Imagine putting the money into that same account at just 5% interest. So, you are getting half the interest. The effect is devastating. Your initial R1 investment at a 5% return compounded over 52 years is worth just R13.39.
Still think putting money in the bank is a good idea?
The lesson is huge. If you don’t review the returns you are getting on your investments regularly and gun for the best possible return, it is going to cost you a fortune over the long term.
Want to know what would have happened to that R1 had you invested it in the market? Market data shows the JSE has grown on average at 19.46% a year over 52 years. So the market has grown at roughly twice the best interest rate I have offered you today. Money in the bank at 10% a year, got you R177.41.
What if you doubled the average return over that same period?
It would have taken about 31.5 years for you to accumulate as much as you would have in 52 years of keeping cash in the bank, but the miracle of growing at almost 20% a year on top of that becomes remarkable. By Year 30, that investment is worth 207.34. By Year 40 it’s worth R1,227.16. It’s not a very big number yet. But growth on growth on growth means that by Year 52, that R1 is worth R10,365.03.
Imagine only cashing that in on the 60th anniversary of that investment. In that eight-year period, that original R1 is suddenly worth an extraordinary R42,988.34.
Imagine leaving it till you are 65.
Okay, I will do the sums.
It more than doubles to R104,583.50.
Let me freak you out even more.
R10 over 65 years growing at 19.46%: R1,045,835.01. Yes. More than R1m.
R100 over 65 years at 19.46%?
You’re getting the picture by now. R10m.
This is the part where I sound like one of those financial services ads. Past performance is no guarantee of future performance and there is no way of telling what the future holds.
What this little exercise should show you is that every single percentage point in growth matters over time. The longer you leave your money to grow, the more it will be worth thanks to the power of compounding. Leaving money in the bank over long periods of time is not an investment strategy, it’s a long slow-burn to poverty.
Happy savings month.