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The Power of Compounding
Article Last Updated: 3 February 2021
Compound interest is a powerful force. It can magnify returns and exacerbate liabilities. It is therefore crucial that investors understand the effects of compounding. As Albert Einstein said, “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t…. pays it.” In order to benefit from the effects of compounding, you have to understand how it works. Once you understand the power of compounding, you can harness it to your advantage.
What is compounding?
When people refer to compounding in relation to investments, they're talking about the process whereby investment returns are reinvested to generate additional returns over time. To benefit from compounding, you need to reinvest the returns earned on your investments. The returns are then compounded, because you earn returns from both the initial investment and its accumulated returns. Essentially, this means earning returns on your returns, which allows your wealth to grow at an accelerated rate.
The effects of compounding apply equally to investments in ASX shares and investments in the form of cash in the bank. With the former, you can reinvest dividends paid on your ASX shares. With the latter, you can bank interest earned on your principal. Then in future you will earn dividends on your dividends and interest on your interest.
How does compounding work?
Compounding requires three ingredients to work; money, earnings, and time. With these three ingredients, you can create a snowball effect - when you roll a small snowball down a hill it will continuously pick up snow, becoming a giant boulder by the time it reaches the bottom. Compounding works in a similar way - as your investment generates earnings, these add to the initial sum you invested, which then produces more and more earnings. Not only are you earning income on your initial investment, you are earning income on your income! Earning compound returns effectively puts your money to work for you. This can result in your wealth rapidly snowballing.
Take a simple example - say you invested $10,000 in a bank account that pays 5% interest per year, and made no withdrawals. After one year you would earn $500 interest. If you reinvested this, allowing compound interest to take effect, you would earn $525 interest in the second year. In the third year you would earn $551 in interest. After 10 years of compound interest and no withdrawals, you would have a total of $16,288 in the bank. After 15 years, you would have $20,789 in the bank, and after 20 years $26,533. As you can see, your earnings begin to grow at an accelerated rate over time.
Compound interest works on both assets and liabilities. So if you have a debt of $10,000 with a 5% interest rate and you allow that interest to capitalise, the debt will increase to $12,155 after 5 years and $16,288 after 10 years. Compound interest works against you when it comes to loans. This is a good reason to keep debts under control. The longer it takes to pay off your loan, the more you’ll owe in interest. If you instead pay the interest and some of the principal off, say $500 per year, your debt will only be worth $7,500 after 5 years and $5,000 after 10.
The magic of compounding lies in its ability to deliver gains on gains. And, over the long term, these gains can really add up. If you invested your $10,000 at 5% annual return and let the returns compound for 50 years, you would finish up with the tidy sum of $114,674. Of this, $104,674 is attributable to interest and interest on interest. If, instead, you spent your $500 interest each year, so that returns did not compound, you would earn a total of $25,000 in interest over the 50 years. The stark contrast in these two amounts illustrates the power of compounding.
What does compounding have to do with investing?
Compounding works the same way on investment returns as it does on interest payments. When you invest in ASX shares, you make a return in the form of dividends or capital gains. When you reinvest those returns you can take advantage of compounding to earn returns on your returns. Over time, the effects of compounding accelerate, amplifying your investment returns even more.
Warren Buffett is a famous beneficiary of compounding. The investment icon turned a net worth of $1 million at age 30 into $1 billion by the age of 56 and is now worth some $70 billion. “My wealth has come from a combination of living in America, some lucky genes, and compound interest,” Buffett has said.
Investors who are looking to grow their wealth will seek to take advantage of the effects of compounding. The key to compounding, however, is time - the more time you have, the more time your investments will have to compound. That’s why it makes sense to start investing early and be consistent. This will pay dividends in the future and help you maximise your wealth. It’s this principle that drives our superannuation system. Your superannuation snowball might start small, but as it rolls it adds layer after layer of investment returns, growing ever larger until it reaches the bottom of the hill (retirement).
The sooner you invest your money, the more you’ll benefit from the effects of compounding. No matter how you choose to invest, the most important step is starting. Once you have started, consistent contributions will help you take full advantage of compounding. The more time an investment has to compound, the greater the returns will be. This is why compounding is an important concept for young investors to understand - the sooner they begin investing, the greater their potential wealth becomes.
Compounding in action
Let’s take a closer look at compound interest in action. Say you invested $20,000 in ASX shares. Let’s also assume those ASX shares pay dividends equivalent to 7% each year. You reinvest the dividends in more ASX shares which then earn more dividends. Over time, the growth in the value of your portfolio would look similar to the below, and that’s without taking into account any capital gains in the value of the shares.
After 15 years, your initial $20,000 investment is worth more than $55,000 thanks to compounding returns. Let’s look at the same example, but this time you contribute an extra $1,000 in savings each year, which you invest in ASX shares. Your return in this scenario would look something like this:
This time your initial $20,000 investment plus $14,000 of annual contributions have, thanks to the power of compounding, grown to $80,310.
How to calculate compound interest
Calculating compound interest is simple using the following formula:
Final amount = Principal amount x (1 + interest rate)years
For example, if you invested $1,000 for 5 years at 7% interest, you would get $1,000 x (1+ 0.07)5 = $1,403.
This assumes that compounding occurs only once yearly. Often it occurs more frequently, such as quarterly or monthly. In this case, you can use the following formula to calculate compound interest:
Final amount = Principal amount x (1 + interest rate)years x n
Where n is the number of compounding periods per year.
There are a bunch of compounding calculators available online which you can use to easily calculate compound returns. This allows you to work out the future value of a given investment, provided you know the rate of return. Rules like the rule of 72 can also be used as a shortcut to work out the future value of an investment.
The rule of 72 is a quick formula used to calculate the number of years required to double an amount of money invested at a given rate of return. The rule of 72 is:
Years to double investment = 72 ÷ rate of return on investment
So, for example, if the rate of return on an investment is 7% it will take 72 ÷ 7 = 10.3 years to double that investment.
How to take advantage of compounding
As mentioned, you only need three inputs to take advantage of compounding - time, money and earnings. The effects of compounding, however, will vary depending on the specifics of those inputs. Your returns will be greater the more often you compound them. So if you have two otherwise identical investments, but one compounds twice as often as the other, the one that compounds more frequently will earn greater returns over the long term. This is because the more frequently earnings are compounded, the more rapidly your principal balance will grow.
You can also increase your returns from compounding by increasing the rate at which you accumulate earnings or earn interest. Interest rates on cash in the bank are currently at record lows meaning many investors are searching elsewhere for higher returns. Fixed income securities such as bonds usually offer a higher rate of return than cash in the bank but, over the long term, equity investments such as ASX shares tend to earn higher returns than bonds.
Finally, the longer you leave your investments to compound the greater the effects of compounding will be. Time is the magic ingredient in the compounding formula. An investment that is left untouched for decades can add up to a sizeable sum, even if you never add another dollar to the original investment. That’s what makes compounding so powerful, and how it can help you exponentially grow your wealth.