In my post, The Power of Compounding, we looked at simple versus compound returns. Now let us examine some very important investing lessons resulting from the power of compounding. If you can adhere to these lessons, you will greatly enhance your investment returns.
For all the lessons below, we shall use the same basic data from the following example:
You invest $1000 in a bond fund that earns a 10% rate of return, compounded annually. Earned interest is reinvested in further units of the fund. Taxes and transaction costs are ignored. At the end of 10 years your investment will be worth $2594 (total interest income of $1594 and your $1000 initial investment).
Assuming all other variables remain unchanged, here are the lessons to remember:
The longer the investment period, the greater the impact of compounding.
Time is a crucial component for compounding.
In our example above, after 10 years your initial investment grew to $2594. Not bad. But if you leave that money alone for 50 years, your one time investment of $1000 grows to $117,391. Impressive.
Over that 50 years, you only earned $5000 (50 years X $100 per year interest) in simple return. The rest of the increase is due to compounding. That is, interest earned on interest.
The farther out the year, the greater its impact of compounding.
After 10 years at 10%, you end up with $2594.
If you need the cash after year 9, you only get $2358. Not that bad, but you lose more than just the $200 simple return. You lose an extra $36 in interest due to compounding
However, if you need the money in year 49, you only receive $106,719 versus the $117,391 if you held out until year 50. That lost $10,672 is huge. And almost all of it reflects the compound interest effect.
The higher the rate of return, the greater the impact of compounding.
All else equal, the rate of return has a big influence on performance.
At a 10% compound return, a single $1000 investment grows to $2594 in 10 years and to $117,391 in 50 years.
Had you found an extra percent return, the impact is noticeable. Over 10 years, you end up at $2839, an improvement of 9.5%. Over 50 years, you get $184,565, a change of 57%.
The more periods in a year an investment compounds, the greater the impact of compounding.
The greater the periods, the more times your interest will be calculated and the sooner the next round of compounding can begin.
In our first example, interest was compounded on an annual basis. That gave us the end values of $2594 over 10 years and $117,391 over 50 years.
Compounding monthly, our investment grows to $2707 in 10 years and $145,369 in 50 years.
And daily compounding results in asset values of $2718 in 10 years and $148,312 in 50 years.
Exactly the same investment with the same time frame. Yet, just by accelerating the compound periods you are able to increase your overall return.
The less your costs, the greater the impact of compounding.
Costs such as taxes, management fees, and transaction costs, all reduce your monetary return. Less return translates into less money being reinvested. That significantly affects the power of compounding over time. Be very aware of this.
Without being too detailed, let’s assume you pay a reasonable 30% tax rate on your earned income. So for each $100 in interest you earn, only $70 can be reinvested. In essence, your annual return has fallen to 7% from 10%.
In our example, your $1000 would only grow over the 10 years to $1967 and not $2594. The government took $300 in taxes, but you also lost $327 in compound interest.
If so, stop reading now because over 50 years, you would only finish with $29,457 after tax adjustments and not the $117,391 before tax.
The same holds true for other costs, such as management fees and transaction costs. Money paid to others will not accumulate on your behalf.
We will look at ways to minimize costs at a later date.
Being young, you have a very long time horizon in which to invest. This is great for compounding your returns.
Being young also allows many of you to take on higher levels of risk in an attempt to earn better returns. The relationship between risk and expected return will be examined at a later date.
As for investment costs, in the near future, we will review ways to minimize these as much as is possible.
I hope this clarifies the concept of compound interest and that you begin to take advantage of it.
Next up, a couple of real life examples on how compounding impacts asset growth.