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The most important financial concept you need to grasp before investing for your retirement

Building your retirement nest egg can be a daunting task that is made more challenging by alien financial concepts and jargon.

The good news is you don’t need a finance degree to be a successful long-term investor although there is one concept you need to understand as it will make a very big difference to your retirement.

This concept is “compounding” and it’s one of the big reasons why shares make a better early investment over property for your retirement portfolio.

Don’t get me wrong, I think investing in property is great and that’s why it forms part of my retirement strategy – but the power of compounding means equities make a better starting point for most retirement portfolios.

What’s compounding

For those who don’t understand compounding, it’s essentially reinvesting the returns from an investment.

Anyone with a savings account that pays interest will enjoy this benefit as the interest paid is added to your initial deposit. This means the amount you get from interest payments goes up in subsequent periods as your deposit grows.

You can’t generally plough your rental returns back into the same asset class but you can with shares.

The compounding effect can be achieved if you invested in blue-chip ASX shares that have a dividend reinvestment plan (DRP).

Instead of being paid a cash dividend twice a year, most large cap companies can issue you shares instead – and quite often at a discount to the market value of their shares.

I don’t like participating in DRPs because I like to pick when to buy a stock. But I can get my compounding effect by reinvesting my cash dividends back into the market with the freedom of choosing what to buy and when.

What impact compounding can have on your retirement savings

Some might think that compounding the modest returns from dividends or cash accounts won’t make much difference to your retirement savings.

But the effect of compounding can be significant over the longer-term even on a relatively modest rate of return.

For instance, if you can make a 3% return on your initial capital of $10,000, by year 10 you would be receiving over $391 (assuming your make no withdrawals) a year.

You’d probably do much better if you invested in a diversified portfolio of quality blue-chip stocks given that the average yield on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) stands at between 4% to 5% (before franking) – and that’s not even considering the boost from a discounted DRP programme.

If you made 5% return instead, the $10,000 outlay would generate an annual return of over $775 – that’s nearly 3 percentage points above the initial 5% you were getting, and that’s nothing to sneeze at!

Stretch this out over a longer time period till your retirement and factor in other capital contributions from the superannuation system and your savings, and you can see why financial experts love compounding.

This example assumes you don’t make any withdrawals and ignores capital gains or losses.

Changes in capital value is one of the big drawcards to Australian property. Up till recently, many property investors have forgotten that capital values can actually fall.

Regardless of the direction of house prices, shares also provides the potential for capital gains. Combine the above benefits with its lower capital requirement, low transaction costs and relatively high levels of market transparency, you can see why shares could be a better asset class to start building your retirement savings.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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