According to legendary scientist, Albert Einstein, what is the most powerful force in the universe? The answer is compounding. Pretty bold claim some might think, but who are we to mess with history?
In a financial sense, compounding (otherwise known as compound interest) is the process whereby returns made on an investment are reinvested in order to generate subsequent returns of their own.
In other words, compounding refers to generating earnings from previous earnings.
The concept of compounding is best explained through the use of examples - so, meet twins Annie and Vanessa.
Example 1 – Annie and Vanessa
Annie and Vanessa both allocated $10,000 to the same interest-bearing investment on their 25th birthday. For simplicity, let’s assume the investment pays interest of 5% per year.
Annie reinvests all of her interest every year, while Vanessa takes the $500 each year and spends it on everyday living expenses. By their 45th birthdays, Annie had a total investment value of $26,533, while Vanessa only saw her total value come to $20,000 (of course, these values include their original $10,000 investment).
While Vanessa earned $500 interest each and every year for the 20-year period - totaling $10,000 - Annie saw her investment grow to more than $26,000 by reinvesting her interest. The additional $6,500 she earned over and above Vanessa highlights the power of compounding.
Annie’s investment is now earning her $1,263 per year, while Vanessa’s investment is still earning her only $500. And this differential would continue to grow over time if the sisters remained invested.
To give you a better picture, these tables illustrate the effect of reinvesting interest by comparing Annie and Vanessa’s investments over the 20-year period.
Vanessa’s investment:
Annie’s investment:
On top of this, the power of compounding can be magnified if you make small regular contributions to your investment. Let’s look at another example to highlight this concept. Introducing brothers Jim, Dan and Tom…
Example 2 – Jim, Dan and Tom
Jim, Dan and Tom all decided to invest $10,000 in the same managed fund for 10 years. Over that time the fund returned an average of 8% pa.
Happy with his original investment decision, Jim did not make any additional contributions. Dan, the wiser brother, understood the effects of compounding and made additional regular savings of $100 per month. Tom – the wisest of them all – worked out he could afford to save an extra $200 per month and made sure he always contributed that amount to his investment. The difference in their investment returns over 10 years is startling:
Effect of compounding with regular contributions over 10 years:
Source: CFSGAM. Figures used for illustrative purposes only.
Of course, these examples are stylised ones, as they ignore potential fluctuations in investment returns over the period, which could affect the outcomes in reality. However, they highlight how compounding and contributing regularly to an investment can have a major influence on investment performance.
The long-term performance impact of compounding can be significant. It’s not a new concept – in fact many of us may have heard of it before in some form or another - but now it’s time to start doing it!
So, with that, why not come in and speak to us for advice around how to make compounding work for you!