Chances are you've heard of compounding and the power of compound interest when it comes to investing in ASX shares. There's a famous quote that's usually attributed to Albert Einstein regarding compounding, which is often bandied about. It goes something like "compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn't, pays it".
Put simply, compound interest is earning interest on interest. Given enough time and the right rate of return, it is quite simply a life-changing force, financially speaking.
It's what can turn $100,000 into $1.74 million over 30 years at a 10% return, assuming no additional investments.
But it's easy to wax lyrical about the wonders of compounding. What's hard is harnessing this incredible power to boost your own wealth.
So today, let's discuss three compound interest tips you can use to hopefully turbocharge your own ASX share portfolio.
Three ways to turbocharge the compounding of an ASX share portfolio
Invest in the right ASX shares
This might sound obvious, but choosing the right ASX shares is an essential step if you wish to truly harness compound interest in your portfolio. A company's shares will only compound in value over long periods of time if that company's profits are also compounding. One of the ways I find companies that have this power is by analysing pricing power.
The name of the game is to identify products that can be consistently raised in price by more than the rate of inflation without severely affecting sales volumes. These tend to be products that people either love or need, and which cannot be substituted.
Some examples might include Coca-Cola, Victoria Bitter, an iPhone, one of Transurban Group (ASX: TCL)'s toll roads, or perhaps Telstra Group Ltd (ASX: TLS)'s mobile network.
Similarly, many workers need to use certain software to carry out their jobs. That could be Microsoft's Office suite, or perhaps Adobe's Creative Cloud.
All of these companies can typically raise prices every year without losing too many customers. As such, they have historically been market-beating investments that have compounded over many years.
Avoid stocks that don't compound
Just as there are many companies that can demonstrate an ability to harness compound interest, there are others that can't. Usually, these companies don't make for the best long-term investments. One sector that I don't think offers a great deal of long-term compounding returns is resources and energy stocks.
Unlike other companies, businesses that make money from extracting and selling commodities don't have any control over what they can sell the commodities for. Woodside Energy Group Ltd (ASX: WDS), for example, has to sell its oil at whatever the global oil price is at any given moment.
Commodity prices can be highly cyclical, but they don't tend to compound over time. To illustrate, West Texas Intermediate (WTI) crude oil is, at the time of writing, asking US$72.10 per barrel. That's the same price it was going for back in April 2006.
Oil companies can use their profits to expand operations and buy new wells, of course. However, their profits simply cannot compound in the same way that a company like Apple's can. Investors still 'buy low' and sell high' with these kinds of stocks, and can make a lot of money doing so. But for set-and-forget, long-term investors who want to stick with consistent compounders, I think there are better places to look.
Reinvest your dividends
Finally, if you wish to truly harness compounding, make sure you are reinvesting any dividends you receive into additional shares. Most shares on the ASX pay regular dividends. These form an important component of the overall returns one can enjoy from investing. Yet it is sadly common to see investors taking their dividend cash and spending it on everyday purchases. Unless you're a retiree who lives on dividend income, this is probably the wrong move to make if you want to turbocharge your wealth.
By taking any dividend cash you receive and using it to buy more shares, you are securing an even larger income stream in the future. This is compounding in action, as the additional shares you buy could pay you even more cash, which you can then take and buy even more shares, and so on. This is why some investors refer to dividend investing as building a 'snowball'.
Many companies and exchange-traded funds (ETFs) offer automatic dividend reinvestment plans (DRPs), which will reinvest your dividends for you every time. So if you are someone who gets tempted to splurge when it's dividend pay day, you might wish to tick that box.
Foolish Takeaway
If you want to get the best bang for your buck on the share market, having a basic understanding of how compounding works and the best ways to harness its power is essential. As Einstein said, those who understand it, earn it. Be one of those people.
