Help your child retire a millionaire on a $2,000 investment

 

This was the eye-catching premise of a Hatch advert that circulated New Zealand in June of this year.

Hatch were not claiming that they had discovered some incredible investment opportunity. 

They were simply illustrating the power of compound returns.

The article explains that if you invested $2,040 when your child is born, and it grows at 10% per year, by the age of 65 it will be worth more than $1,000,000.

There is a famous quote attributed to Albert Einstein:

        "Compound interest is the eighth wonder of the world. He who understands it, earns it; 

          he who doesn't, pays it."

While it is highly likely that he said no such thing, the power of compounding is truly a wonder to behold.

As Doug McCutcheon pointed out in an article in the Globe & Mail: 

"If you invest a sum of money at 10% for five years, you will multiply your wealth by 1.6 times.  If you invest your capital at that rate for 50 years, you will not multiply your wealth by 16 times (10 x 1.6). You will in fact multiply it by 117."

The second part of the Einstein quote is also true of course, you do not want to be paying interest where you can avoid it.

Most people know that credit card debt is not a good thing to carry, and pay off any balance monthly. However often people don't think in the same way about their mortgage. This is more "acceptable" debt.

This is despite the fact that the interest paid over the term is very substantial.

Even at todays low interest rates, you'll easily end up paying 50% more than you borrowed.

For example, if you borrow $500,000 over a thirty year term, at 3.15% per annum, the total cost will 

be $750,586. 

Incidentally if rates increase by just 0.5% (as seems very possible) that would increase the overall cost of the mortgage by $42,342.

Instead of a rate rise, imagine that you reduced the term by five years. Now you're reducing the overall cost by $44,713.

How likely is annual growth of 10%?

Getting back to the Hatch illustration, people might well think "that's all very well, but 10% per year seems quite unlikely". 

Of course some years there will be no growth at all: the market will fall overall. Growth will not continue in a linear fashion. But as the article points out, markets such as the American S&P 500 (the most popular index in the world) have enjoyed average annual growth of around 10% for almost a century.

So the premise certainly has merit.

Conclusion

Whether you opt for the Hatch option or another, I believe that the eye-catching tag line is another welcome inducement for people to understand the benefits of compounding and investing for the long term.

Setting up a low-cost investment account for your children is an excellent idea. Whether you make a single investment or monthly contributions (which I would personally advocate due to the effect of dollar/cost averaging) you may well be amazed at the results after twenty years. See my previous blog on the rival platform Sharesies for ideas on what to invest in.

Also, the exercise can really help with your child's financial literacy. As with the family challenge in an earlier blog, you might want to share some of the performance information with your child over time. If you choose to invest for them in a Kiwisaver account, then there's no danger of them thinking that they can simply spend the money! It would be for their first house deposit and their retirement.

You can of course also highlight the perils of compounding interest on debt while you're at it!

Dunotter disclosures

Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.