The Power of Compounding

On 12/09/2009, in Investment Concepts, by Jordan Wilson
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The power of compounding may be the most important investment concept for young adults to learn. Understanding and applying this principle will earn you more return than any investment tip you will ever receive.

Got your attention?  

Good. Because first we need to look at some calculations to understand compound return.

For the examples below, we will keep it straightforward. We shall assume this is a typical economist’s world with no taxes, no transaction costs, reinvestments at the prevailing rates, etc. In short, a world that would amaze Harry Potter and his friends.

Simple Returns

Most of you are familiar with simple return. That is the return you receive from an investment in interest, dividends, or capital.

The important thing with simple return is that the money earned on the investment is not re-invested. You receive the interest or dividend and then you promptly spend it celebrating your shrewd investment skills.

Example

You purchase a $1000 bond at face value with a 10% interest rate paid annually.

Each year you receive $100 in interest for a simple return of 10% annually. Time for Happy Hour at the pub, so the money is quickly spent on beer and aspirin.

At the end of the 10 years, the bond matures and you are paid back your original $1000. The net return was also $1000 over the 10 years (10 payments of $100 per year).

You might also consider returns in your own life. Anywhere you work involves a return on your efforts.

Let’s say you work the summer in a factory. You are paid for each box assembled and each day you can assemble 20 boxes. You pile them in the corner and your boss counts them Friday evening. Then you are paid $100 per box. Work harder and you might get 25 completed. Take it easy and you get less done. Friday night you should have 100 boxes completed and get paid $1000. The 100 boxes and the $1000 are the simple return for your labour.

Compound Returns

Compound returns are like simple returns, except you do not spend the money you receive from the investment. Instead, you reinvest the receipts at the same rate of return as the original investment.

Example

You purchase a bond fund that will yield 10% annually for your $1000. Essentially the same investment as above. However, interest earned on the fund is automatically reinvested in the fund so that your returns compound annually.

At the end of year one, you earn $100. Same as with the simple return. But instead of getting a cheque for $100, the interest is automatically reinvested in additional fund units. Sorry, no money for the pub. But on the positive side, no massive hangover the next day either.

Well, maybe that is not the only positive. That $100 of earned interest will start to earn interest itself for the remaining 9 years of the investment. And that is the key to the power of compounding.

At the end of year two, your original $1000 will have earned another $100. Plus your year 1 interest of $100 will have returned an additional $10. This pattern continues over the life of the investment.

Each penny you earn on your investment will itself begin to generate its own future returns. And that future return will also start earning a return.

Now $10 here and there may not seem like much, but over time it really adds up.

In this example, at the end of 10 years your investment has earned you $1594. Compare this with the $1000 under the simple return and you did significantly better under the compound return.

Through the compounding in this example, you generated an extra 59% return over the 10 years. Not too bad for no cost to you.

If we look at the warehouse job again, think of it as a factory from the world of Harry Potter. On day one, you assemble your 20 boxes. On day two, you assemble another 20, but you notice the boxes from day one have risen up and started assembling more boxes themselves. By day’s end your pile has 20 boxes in it, but the boxes have contributed another 3, for a total of 23. A greater result, yet you did not work any harder.

On day three, you keep working on your 20 boxes. Again, those other boxes are assisting. As there are now 43 boxes to start day three, they generate 6.5 boxes rather than the prior day’s 3.

When your boss does the Friday count you are surprised to find 135 boxes assembled. You only assembled 100, but you ended up with a lot extra. And, as the boxes do not get paid, you get the entire $135o for yourself.

You head home to enjoy the weekend, realizing that come Monday, the boxes will start producing more additional boxes each day than you do yourself. In time you can let them do all the work and assist your boss in finding a bigger warehouse for all the assembled boxes.

That is the power of compounding!

Next up, we shall look at the Compound Return Investment Lessons.

2 Responses to “The Power of Compounding”

  1. Anonymous says:

    In the introduction to Niall Ferguson’s, The Ascent of Money, he shares the following: “A 2008 survey revealed that two thirds of Americans did not understand how compound interest worked.” I had no idea that this concept was foreign to so many. Great post!

  2. JMW says:

    Thanks for the comment. It is always amazing how little people know about things that are so important for their success in life.



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