The Motley Fool

What is Compounding? – A Beginner’s Guide To Investing – #AskAFool Video

“What is compounding, and why is it important to investors?”
We hear this question a lot from people who are in the early stages of learning about investing. It’s a perfectly valid question, so we put it to members of our investing team to discuss.

VIDEO TRANSCRIPT

RYAN: Scott what is compounding and why is it important to us as investors?

SCOTT: Yeah, great question. The best way to describe compounding is with a saying that is: “Your money, makes money”. So there is the old quote: “You have to have money “to make money.” and that’s true to some degree, but I don’t want people to be put off. The reality is if you have a Dollar and you had 10% return, you got a $1.10. If you had a 10% return on that, you’ll add 11 cents, rather than the previous 10 cents and so on and so forth. So, your Dollar becomes two, which become four, which becomes eight, which becomes 16. We don’t have to add any more money, you’re simply relying on the returns. The money, making money, making money, making money. That kind of, you’re building up a pyramid if you like. You’re building a constant growth into your investing and that’s what compounding is at it’s very, very core. It’s not only earning 10% on the same amount, if you had cash in the bank, you earn two percent. You earn $2.00 on your 100, next year you’ll earn $2.00 on your 100, next year you’ll earn $2.00 on your 100. That’s a flat line investment. But if you compound, if you re-invest those returns or you keep the returns inside a portfolio, that’s exactly how they compound. Whether it’s re-investing the dividends, getting higher share prices, hopefully also adding money to the portfolio, when your money’s making money making money, that’s the real asset of compounding. That’s how you go from a Dollar, to two, four, eight, 16 and on from there.

RYAN: So it sounds like compounding is even more powerful as the percentage returns increase.

SCOTT: Yeah it is. So you’ll want two things. Time and the rate of return and if you can maximise both of those, that’s where the real value is. The difference between 10% compound and 12% compound is not just two percentage points or 20%, the difference between 12 and 10, it can be multiples of your investment. Because you’re getting the 12 every single year, so it’s actually compounding that return value. And again, time is of the essence right? If you can double your money every seven years, which is about the average return on stocks over the long term. Yeah so the Dollar becomes two, becomes four, becomes eight, now if you stop there, that’s as much time as you’ve got and you stop there, if you can get one more compound level up to 16, that last compound is really where most of the value is. So the rate of return maximise that where you can and maximise where you can, the length of time you’re compounding for. Start early, leave the money for as long as you possibly can, get the best return you can, that’s the secret.

RYAN: I think there’s a really interesting fact about Warren Buffett as well after his 50th birthday. Would you mind sharing that?

SCOTT: Yeah so it depends on the, something like at least 95% of his current wealth. Current wealth, he basically earned after his 50th birthday in other words when he turned 50, he was already worth a fortune. Effectively what that said was at that point, his wealth was going to increase 20-fold, between then and now. And so that’s really where the value is, that’s again that same point of the last lot of compounding you do, because your compounding the same way return on a larger base, that’s where the value is. And if you can start as early as you possibly can, the best time to start would have been 10 years ago. The second best time is today to get the most out of compounding.

RYAN: Excellent. Thanks Scott.

SCOTT: Thanks Ryan.