Many individuals develop a financial plan around leaving a ‘nest egg’ for their children one day. Whether this is to help with their child’s first property purchase, to pay off debt, to pay for grandkids’ schooling or university, or even just for an overseas holiday, we, as humans, are naturally driven to take care of our families as best we can. However, with the advancement of modern medicine, many people are living longer than expected and therefore the possibility of leaving money for our heirs begins to dissipate with increased life expectancy. With this in mind, I’ve always advocated for parents to leave their children with something more important than money on their passing: investment/financial literacy.  I’m not even going to get into the debate on how undertaught this subject is in our schooling system with most people in this country matriculating without knowing how a bond repayment works, what the contribution limits are in a TFSA, or the benefits of investing early through compound interest. The fact that these gaps in knowledge exist is concerning and plugging these gaps will enhance an individual’s overall potential to succeed.

Here is an example: Friday nights are pizza nights for my family and generally cost around R400. That is roughly R1600 per month. If we were to scrap this and go grocery shopping every Friday, the bill would come to around R150 for that Friday night or R600 per month, R1000 per month cheaper than the pizza option. Keep this figure in mind as we move forward in this article.

Compound interest, referred to as the eighth wonder of the world by Albert Einstein, is a financial concept that has the potential to transform your financial future. This powerful principle allows your money to work for you, earning returns not just on your initial investment but also on the accumulated gains from previous periods. At its core, compound interest is the process of reinvesting the returns generated from your investments. When you reinvest your earnings, they start generating returns of their own, creating a snowball effect that can lead to substantial wealth accumulation over time.

The Magic of Compounding:

To illustrate the power of compound interest, consider the following example. Suppose you invest R1000 in a diversified portfolio with an average annual return of 10%. In the first year, your investment grows by R100, bringing your total to R1 100. In the second year, you earn 10% on R1 100, resulting in a gain of R110, and so on.

Here's a simplified formula to calculate the future value of an investment with compound interest:

FV = PV x (1 + r) n

Where:

• FV = Future Value
• PV = Present Value (initial investment)
• r = Annual interest rate (as a decimal)
• n = Number of compounding periods

Going back to the pizza, suppose you invested R1 000 per month every month for 10 years. Assuming a 10% pa return, after 10 years, you would have approximately R206 552.

The Time Factor:

One key factor that significantly influences the power of compounding is time. The longer your money is invested, the more time it has to grow exponentially. Using a different example, suppose you were to invest a lump sum of R100 000 for 30 years at an average rate of 10%. After 30 years you would end up with roughly R1 900 000.  Whilst these figures seem remarkable, it is important to mention the inflation caveat here. R1 900 000 in 30 years is worth roughly R370 000 in today’s terms – still a very positive real return.

One thing to note, investing in the market is important here: If you invested the same amount for 30 years into a bank savings account (using average interest rates over the last 30 years) you would only have R575 000 – around R1.3M less.

Of course, these examples are anecdotal, but the key point remains: If you cut your expenditure, even slightly, and invest the difference appropriately, the results can be life-changing over a long period of time. Nail this investment mindset into your children’s psyche and they will be better for it.
  

Harnessing Compound Interest:

To harness the power of compound interest effectively, follow these key principles:

1. Start Early: Begin investing as soon as possible to give your money more time to grow.
2. Consistent Contributions: Make regular contributions to your investment portfolio to fuel the compounding process.
3. Diversification: Diversify your investments to manage risk while maximising returns. A qualified financial advisor can be a great help in this regard.
4. Reinvest Dividends and Interest: Instead of cashing out, reinvest any dividends or interest earned to capitalise on compounding.
5. Patience: Understand that the real magic of compounding happens over the long term, so stay committed to your investment strategy.

If leaving a nest egg is imperative to you as a parent, the easiest way to ensure this is to start a unit trust/tax free investment in your child’s name the day they are born (and disclosing this as a donation). Investing R1000 per month from the start can result in them having a large amount of money in their name by adulthood. This is also more tax efficient than leaving them a large amount of money on death as donations are exempt from tax up to R100 000 per year. Lastly, I would encourage parents to include their children in review meetings with their financial advisor once they are of an appropriate age. This will provide the child with more understanding and depth regarding different financial products and will also ensure a relationship is built with the family’s advisor. The importance of this cannot be overstated.

Read more from Jono 
  

This article was originally published on Moneyweb on 2 February 2024 as part of the financial advisory view articles. The original can be accessed here