WHEN it comes to investing, it’s easy to overlook the impact that small differences in returns can have on your financial future. After all, a 1 per cent difference in the rate of return might seem trivial when considered in isolation, especially when compared to the effort involved in moving your investments.

However, over time, this seemingly minor difference can lead to significantly different outcomes, thanks to the power of compounding. Understanding this concept can be the key to making more informed investment decisions and ultimately achieving greater financial success.

What Is Compounding?

Compounding is the process where the earnings on your investment generate their own earnings. In other words, you’re not just earning returns on your initial investment; you’re also earning returns on the returns. This snowball effect means that the longer your money is invested, the more pronounced the impact of compounding becomes.

Consider an initial investment of $100,000 with a 5 per cent annual return. After 20 years, this investment would grow to approximately $265,000. However, if the rate of return were increased by a mere 1 per cent to 6 per cent, the investment would grow to roughly $321,000 over the same period. This 1 per cent difference in the rate of return results in an additional $56,000, or 56 per cent more growth.

The Long-Term Impact of 1%

The impact of a 1 per cent difference in returns becomes even more significant when viewed over longer periods or with larger sums of money. For instance, over 30 years, the $100,000 investment with a 5 per cent return would grow to around $432,000. With a 6 per cent return, it would grow to nearly $575,000 — a difference of $143,000. This demonstrates how the compounding effect accelerates over time, magnifying the difference that a small increase in returns can make.

Moreover, if you’re investing larger sums, the impact of this 1 per cent difference becomes even more pronounced. For example, with a $500,000 investment, the difference in growth between a 5 per cent and 6 per cent return over 20 years would be $280,000 — a significant amount that could translate into your dream home, early retirement, or a financial safety net.

Why You Should Care About 1%

In a world where investors are bombarded with opportunities and choices, it is easy to dismiss the importance of small differences in returns. However, the examples above illustrate that these small differences can add up to substantial amounts over time. By focusing on achieving even a slightly higher return, investors can significantly enhance their financial outcomes and build greater wealth over time.

This doesn’t mean that chasing the highest return at all costs is advisable. Risk, diversification, and financial goals should always be considered and the value of good customer service, fulsome information and communication from your financial advisor is priceless and shouldn’t be ignored. However, understanding the power of compounding can help investors appreciate why seemingly small differences in returns are worth paying attention to.

In conclusion, while a 1 per cent difference in investment returns might seem negligible in the short term, over time it can lead to dramatically different financial outcomes. By taking advantage of the power of compounding, investors can make their money work harder for them, ultimately leading to greater financial security and success. But while every percentage counts, especially when it comes to your future, don’t blindly chase rates without considering the risks and doing your research before making a move for a higher rate.

Toni-Ann Neita-Elliott, CFP is the Vice-President, Sales & Marketing at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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