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.
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:
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.
Source: Colonial First State, May 2014
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