23 April 2021
When it comes to investing for your future and your retirement, there is no question it is a long-term game. The life expectancy for someone aged 65 is 84.9 for men and 87.6 for women, so as our lifespan increases, it’s important to plan for that.
We need substantially more retirement savings today than we did 30 years ago and that should be your focus, not the short-term share market ups and downs.
Taking a long-term view also helps to remove much of the stress of investing; the longer you are invested, the more confident you can be about your overall likely return.
Here are some further benefits you can expect to see when you invest for the long term and start your investment plan sooner rather than later.
As Einstein reportedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
Compound interest is when you add the earned interest back into your investment, which then earns you even more interest, compounding your returns. So, you’re not just earning interest on your initial investment. You’re earning interest on your interest.
The power of compounding helps you to accrue more money; the longer you invest, the more returns your investments earn.
For this reason, the secret to meeting your financial goals is starting an investment plan as early as possible, as this will help ensure you have a greater amount at retirement than if you were to try to catch up later.
The benefits of compound interest are part of the reason compulsory superannuation contributions were introduced. The principles of compound interest can give people a better chance to accumulate sufficient funds for retirement the earlier in their career they start to make super contributions.
Say you earn $158,000 gross and have $200,000 in super and plan to retire in 20 years’ time. For the purposes of the exercise, we will assume you are receiving super guarantee contributions of $15,000 p.a. and the rate of return on your super over the 20 years is 7% p.a. (before tax, we assume the tax rate on superannuation earnings is 15%).
In Figure 1, the blue line demonstrates what will happen if you make additional after-tax contributions of $20,000 p.a. for the first 10 years.
The red line show what happens if you make a lump sum contribution of $266,000 (the equivalent of 10 x $20,000 payments in future dollar terms) right before retirement.
Due to the benefits of compound interest, making the annual contributions of $20,000 early on in your investment timeline will result in an additional $250,000 or a balance which is 17% higher than if you chose to invest a lump sum contribution close to retirement.
Range of returns narrow over time
Another benefit of long-term investing is your expected return can become more certain the longer your investment timeframe.
Figure 2 refers to the Australian share index (S&P/ASX 200) over the last 30 years, which had an average return of 11.05%.
On an annual basis since 1980, the returns of this Index have ranged from a high of 86% to a low of negative 40%. However, for longer holding periods of five or ten years, the picture changes significantly and the range of returns reduces to:
- Positive 40% to negative 4% over five-year periods; and
- Between 15% and 3% over ten-year periods.
Time is your friend when it comes to investing; it can be easier to make predictions further out into the future than it is to predict what will happen in the next 12 months.
It's not about timing the market - it's about time in the market
Markets are unpredictable and trying to time them means you must get two important decisions right - when to get out and when to get back in (or vice versa).
The benefit of being focused on a long-term outcome and staying invested over the long run is your investment risk is reduced by removing lost opportunities. Trying to jump in and out of the market can result in you missing big up days in the market as illustrated in Figure 3.
The coloured areas show the resulting end value and the shaded areas show the capital gains foregone, under each of the scenarios.
As the saying goes, “The ball may drop, but you’ll want to make sure you’re there for the bounce,” which is so true when it comes to investing in equity markets.
It is easy to get caught up in the daily ‘noise’ of investment markets, but don’t let this be a distraction to putting a financial and investment plan in place now. The best thing you can do for your “future self” is to start planning (and investing) sooner rather than later.
 Australian Life Tables 2015–17, Australian Government Actuary