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Summary

Investors’ decisions – both conscious and subconscious – have an important bearing on their long-term wealth. In this article, we examine the power of compounding.

Content

Investors’ decisions – both conscious and subconscious – have an important bearing on their long-term wealth. In this article, we examine the power of compounding.

Compounding isn’t a new concept – many of us will remember studying it back in our school days. Legendary scientist Albert Einstein famously called it ‘the most powerful force in the universe’, while American business magnate John D Rockefeller suggested compounding is the ‘eighth wonder of the world’.

These might sound like bold claims, but the power of compounding on an investment portfolio should certainly not be underestimated.

What is compounding?

In simple terms, compounding is the process whereby returns made on an investment are reinvested in order to generate subsequent returns of their own.

The concept of compounding is best illustrated using an example. Twins 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 banks the $500 each year and spends it on everyday living expenses. Let’s see how their investments had fared by their 45th birthdays.

Figure 1: Effect of compounding over 20 years

Annie’s investment value ($)

5% compound interest ($)

Vanessa’s investment value ($)

5% interest ($)

10,000

10,000

Year 1

10,500

500

10,000

500

Year 2

11,025

525

10,000

500

Year 3

11,576

551

10,000

500

Year 4

12,155

579

10,000

500

Year 5

12,763

608

10,000

500

Year 6

13,401

638

10,000

500

Year 7

14,071

670

10,000

500

Year 8

14,775

704

10,000

500

Year 9

15,513

739

10,000

500

Year 10

16,289

776

10,000

500

Year 11

17,103

814

10,000

500

Year 12

17,959

855

10,000

500

Year 13

18,856

898

10,000

500

Year 14

19,799

943

10,000

500

Year 15

20,789

990

10,000

500

Year 16

21,829

1,039

10,000

500

Year 17

22,920

1,091

10,000

500

Year 18

24,066

1,146

10,000

500

Year 19

25,270

1,203

10,000

500

Year 20

26,533

1,263

10,000

500

Total value received

26,533

20,000

Source: CFSGAM. Figures used for illustrative purposes only.

Vanessa earned $500 interest each and every year for the 20 year period – a total of $10,000. Of course she still had her original $10,000 investment as well.

Annie, on the other hand, saw her investment grow to more than $26,000 by reinvesting her interest. The additional $6,000 she earned over and above Vanessa highlights the power of compounding. You can see from the table that Annie’s investment is now earning her $1,263 per year, while Vanessa’s investment is still earning her only $500. This differential would continue to grow over time if the sisters remained invested.

Make compounding work even harder for you

The power of compounding can be magnified if you make small regular contributions to your investment. Let’s look at another example to highlight the concept.
Brothers 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:

Initial investment

Monthly contribution

Annual return

Value after 10 years

Jim

$10,000

0

8% pa

$21,589

Dan

$10,000

$100

8% pa

$39,602

Tom

$10,000

$200

8% pa

$57,614

Source: CFSGAM. Figures used for illustrative purposes only.

Of course the example is a stylised one. It ignores potential fluctuations in investment returns over the period, which would affect the three outcomes in reality.

These examples 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 and must not be overlooked by investors. Perhaps Einstein and Rockefeller were right, after all.

Speak to your financial adviser if you have any questions about compounding.

Source: Colonial First State Investments