The benefits of using regular monthly debit orders are many, considering the workings of compound interest, rand-cost averaging and the creation of great investing habits.
Albert Einstein called the magic of compound interest "the eighth wonder of the world". He famously stated that "he who understands it, earns it, and he who doesn't, pays it".
The basic principle of compound interest is that you earn interest on an ever-growing amount of capital, as opposed to on the initial capital only, as when simple interest is applied. Think of compound interest as your profit - and when it compounds, you earn a profit on your profits.
The other basic principle is that there's power in incremental growth and that the number of times the interest is paid the better. For instance, your long-term growth will be far higher if the interest is paid monthly, as opposed to annually.
More to the magic
There's more to the magic, which is that the number of payments you make also enhances growth. The more often you invest, the better. Let's look at the outcome of two different scenarios using simple future value calculations.
If you invest a capital amount of R1,000,000, contribute R100,000 at the end of each year, and earn 10% compound interest, you'll end up with a capital amount of R4,346,859 after 10 years.
But if all the variables remain the same, and you invest R8,333 at the start of every month (R100,000/12), you'll end up with R4,428,239. You earn R81,380 more by contributing monthly.
So, instead of making an annual contribution to your investment, do get monthly debit orders going.
This is especially important for tax-free and retirement investments. The earlier and sooner you get the power of compounding working in your favour, the better.
No timing the market
The next advantage of regular contributions towards your investment is the benefit of rand-cost averaging. When you invest a fixed amount on a regular basis, you buy more units (of shares or unit trusts) when prices are low and fewer when prices are high.
By doing this over a long period, you get a reduced average cost per unit over time.
What's more, by automating your investing and using debit orders, you minimise the risk of losing capital if you invest in lump sums and the market falls.
Sound budgeting
One of the most important processes of wealth creation is sound budgeting. Contributions towards investments using debit orders ensure that you maintain your commitment to the most important line items in your budget, including contri-butions towards retirement funds and other important life goals.
Debit orders take the emotion out of investing and make you stick to your plan.
Equities haven't performed well over the past couple of years, and you may feel tempted to stop your debit orders to your retirement funds until the markets improve, which they will.
But it's a good investment habit to remind yourself that long-term returns matter the most. The long-term average annual return for high-equity unit trusts (up to 75% in equities), which are usually most appropriate for retirement savings, has been 11%.
It is important to remember that this average includes some years when returns have been as high as 43.77% or as low as -36.35%.
Keep faith in your investment strategy, keep the debit orders going, and accept the bad years along with the good.
Stay ahead of the curve
On a final note, do remember that inflation is your enemy and when you set up your debit orders, arrange an annual automatic escalation by at least the inflation rate.
Why not set the escalations at 20% if you've been promoted, or your business is doing very well?
This will help to avoid the perils of lifestyle creep, a self-imposed inflation rate that results in waste.
Hugo, the director of Sterling Wealth and an independent financial planner with certified financial planner accreditation, is the Financial Planning Institute's Financial Planner of the Year for 2018/2019..