05 Nov 2007 | 30 comments | investment | Comments feed

Does Compound Interest Really Apply to Unit Trust Investment?

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Unit trust is an easy means of obtaining a spread of investment. It is suitable for passive investor, who doesn’t want to, or doesn’t have extra time to invest their cash savings. For an investment capital to grow, we must not underestimate the power of compound interest - what Einstein calls the “8th wonder of the world.”

Question from a reader

This is a question from a regular reader:

Does compounding interest really apply in unit trust? if so, can you show me how does it apply? If possible, please include how to forecast an investment in unit trust. For example, if I invest RM10,000 today in equity fund, what will i get in 20 years time? Thank you

In fact, the answer can be “yes”, and also “no”. It depends on how you apply the power of compounding interest. If you know how to apply it, unit trust really shows you the power of compounding effect. If you are not mentally prepared, the power of compounding interest is just a myth.

What is the power of compounding interest?

Let’s look at the definition of compound interest:

Interest that accrues when earnings for a specific period are added to principal; thus interest for the following period is computed on the principal plus accumulated interest.

It means you don’t withdraw the interest earned from you capital. Just let the return stay in your investment account and let it compounds. Your next interest return will be calculated using the accrued principal plus interest.

For example, you save RM1,000 in a Fixed Deposit account giving you 4% interest return per annum. Provided that you don’t withdraw any sen from the account, your account balance will look like this:

After 10 years untouched, you will have a total of RM1480.24 in your FD account. If you keep the money there for another 10 years, it not only earns you another interest of RM480.24, but a total of RM1,191. Leave it there for 50 years, you will get a magnificent total of RM7,107.

Use this compound interest calculator to verify the figures.


Notice the curve line growth which is exponential. The most interest earned is at the last few years. The exponential growth will be more significant towards the end.

How to “employ” compound interest?

Imagine you have a loyal employee called “compound interest”. He will work for you day and night non-stop. All you have to do is not to disturb him at work. Let him concentrate to do his job for you. At the end, he will definitely deliver the magnificent results for your hard earned money.

In order to enjoy the power of compound interest, make sure you provide the perfect working environment:
1. Start saving and investing as soon as possible
2. Let your savings and investment accrued and compound as long as possible
3. Try to get the best investment return with bearable risk


Photo by orangeacid

How to apply compound interest in unit trust investment?

No matter where you put your money, provided the money is still yours, compound interest will work for you. Consider the following places where you save your money

• under your pillow - compound interest still works, but with 0% interest rate.
• in saving account - compound within 1-2%
• in fixed deposit account - compound 3.7% p.a.
• in unit trust - compound with a wider range, say -5% to 20%
• in shares - compound with an even wider range, say -50% to 100%
• in properties - hard to predict. If you buy a house that’s never completed, you lost your capital plus interest charges of your mortgage. However, some experienced property investors can get their money compounded many fold per annum.

But if you spend the money instead, I guarantee that compound interest won’t work for you anymore, because the money is no longer yours.

You can even use borrowed money to invest. For instance, you get a home loan to buy house, or borrow money from your parents to invest in stocks. If you manage to get a higher return than the interest charges, compound interest is working for you.

But if you borrow money to spend, compound interest is working against you. The harder it works, the poorer you are.

In order to let compound interest works its wonder in unit trust investment, you should:

1. Never repurchase your fund unit - let your capital stays in there as long as possible. When you want to lock the gain from time to time, use switching facility.
2. Review your portfolio performance regularly - make sure it is giving you positive return as often as possible
3. Invest as early as possible - start investing when you are still young. It will give you the longer term to invest and get through all the equity roller coaster ride when you reap the return at the end.
4. Invest as much as possible
5. Never get tempted to spend your earning - just leave your return in the fund. Forget about it! Leave it until you reach your financial freedom.

How much can you get from RM10,000 initial investment after 20 years?

Use the compound interest formula to calculates the value of a compound interest investment after ‘n’ interest periods.

FV = PV( 1 + i )ⁿ

where:

‘FV’ = Future value after ‘n’ interest periods.
‘PV’ = Present value of Principal, the amount invested at the start.
‘i’ = the interest rate applying to each period.
‘n’ = the number of interest periods (number of years for per annum computation)

From the reader’s question above,”If possible, please include how to forecast an investment in unit trust. For example, if I invest RM10,000 today in equity fund, what will i get in 20 years time?“. In this case,

PV = RM10,000
n = 20 years
i = whatever annualized return you think your equity fund can produce

Use this compound interest calculator,

When i = 10%
FV= RM67,275

When i = 15%
FV = RM163,665

When i = 25% (Hey, this is better than Warren Buffett’s portfolio, the world’s best investor)
FV = RM867,362

In fact, it depends on how your investment portfolio is doing for the long term. Sometimes an equity fund can give you 40% return in a year. Sometimes it makes a loss of 30% in extreme bear market. If your portfolio can produce 15% return per annum consistently, that’s already marvelous.

To get decent return from unit trust investment, you can refer my articles about:
The secret of unit trust investment
Asset allocation
Portfolio Rebalancing

Summary for Action

Through the power of compounding, a small amount of money over time can grow into a substantial sum. Investments can increase in value over time - and the longer the time frame, the greater the value. This is achieved through returns that are earned, but not spent. When the return is reinvested, you earn a return on the return and a return on that return and so on. Therefore in order to benefit from the power of compounding returns, you must invest as much as possible, in a lump sum now! And keep on investing or saving whenever you got spare cash. Just don’t spend it!

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