Insights

Planning for one's financial goals can be a complex affair. However, one of the most important concepts to be aware of is the effects of compounding on your investments as you are saving for your future. The importance of the concept is explained below.

What are compound returns? Compound returns are returns calculated on the initial principal and also on the previously accumulated returns. With compounding, exponential growth occurs when you derive returns from both your initial investment and returns achieved before.

Making the magic of compounding work for you lies with two key factors: 1) how long you have to invest, and 2) the rate at which your investment grows. The table below shows how exponential growth is achieved when a consistent growth factor or rate or return is applied on an investment's current value over time. Consider the case where an investment grows at 4% per annum. In the first year of growth, a $100,000 investment earns an annual return of $4,000 ($104,000-$100,000). At the 30th year, compounding results in the annual return increasing by more than three times to $12,475 ($324,340 - $311,865).

The second factor impacting investment outcomes is the rate of return. To illustrate, let us consider a $100,000 investment to be invested today. Over a period of 30 years, if the investment grows at a rate of 2% per annum, the investment will grow to $181,136. If the rate of return is improved to 6%, $100,000 can grow to $574,349, more than three times the amount compared to the amount if it had 2% growth per annum. Given the large differences in outcomes, we conclude that achieving a higher rate of return for the long term is therefore of paramount importance to reaching your financial goals.

How does compounding affect us when we are saving towards a long term goal, for say, our retirement? Saving for a long term goal is slightly different from the above scenarios as a third factor comes into play, i.e. the amount of contributions one makes to the financial goal as time passes. Time, however, continues to play a critical role in determining the amount of funds required to save towards a specific goal.

The table below shows the amount of savings required each year, when compounded at a rate of 6%, to save a million dollars at age 65. Clearly, a much lower amount of savings is required if one starts saving early. For a young person with a longer time horizon, the amount of savings required annually and the total cash outlay to reach his/her million dollar goal is significantly lower at about $6,000 p.a. than if he decided to start saving when he is closer to retirement. If he started investing at either ages 35, 45 or 55, as the amount required per annum will approximately double, quadruple or increase by eleven-fold respectively. The total investment amount for the 25-year is also significantly lower, at about a third of the amount required if he starts saving at 55.

In conclusion, how much you will be able to save towards your goals will be affected by the following three key factors:

1. How long you have to save;
2. How much you contribute to goal every year;
3. The rate of investment return achieved.

For young people, the best way to grow your nest egg is to start investing now. For the rest of us, it is better late than never.

Once you have retired, the journey for drawing down your retirement funds will have just begun. The change can be daunting as one becomes a net spender from a net saver. Many people make the mistake of taking a very low level of investment risk at this point. Yet, that in itself could result in serious erosion of the real value of your retirement fund due to inflation.

With UTRADE Robo, we aim to smoothen out the transition as our technology dynamically adjusts the risk level of your portfolio as you progress towards and through retirement. On top of taking into consideration how long you have before you reach your goal, we also take into consideration your expected contribution rate towards and withdrawal rates from your goal.

To illustrate how diversification lets us reduce volatility, let us consider a portfolio that is equal weighted in two asset classes, emerging market equities, and gold.

Both assets class had similar returns of about 9% per annum from 2005 to 2017, but each had their own cycles of ups and downs. Mixing both asset classes in a 50-50% portfolio would have allowed us to maintain returns, while the volatility, or average rate of movement up and down, of the portfolio decreases.

The final benefit of diversification is minimizing single security risk. Losses on any particular security are limited by the exposure to that underlying security. For UTRADE Robo, exposure to any underlying equity security contained within a fund used for portfolio construction should not exceed 4% of the overall portfolio. That implies that the impact on the portfolio is limited to 4% if that particular security suffers from a 100% capital loss.

Part of your portfolio will be allocated to equities, allow you to gain exposure to leading global companies.

While the largest exposure to a single equity security can be up to 4% for a high risk portfolio, the majority of the portfolio will consist of securities with much lower allocations. Across the portfolio, you will diversified across to close to 7,000 securities.