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Why You Should Invest for Compounding Returns
As an investor, compounding returns might be the biggest weapon in your armory. Warren Buffett – perhaps the most profitable investor of all time – called ‘compound interest’ the most powerful factor behind his success. Albert Einstein called compound interest the eighth wonder of the world.
Compounding has helped make Buffett a multi-billionaire, and it is a strategy that you can easily replicate. Simply put, if Warren Buffett employs compounding to boost his success and Einstein thought it to be so wondrous, so should you.
How Does Compounding Work?
Compounding is easy to understand. Instead of taking your interest or dividend out each year, you leave it in your fund. You earn interest on the interest you have received. Over time, as the interest builds up, so, too, do your returns. It’s like a snowball rolling down a hill, getting larger and faster at every revolution.
How Can You Get Compounding Returns?
Growth stocks can explode in value, but they are usually high-risk investments. Compounding growth is a slow and steady investment strategy, with two key features:
- The investment asset must pay you an income. This might be in the form of dividends, interest, or other income.
- You must not take this income. Instead, it should be reinvested into the investment asset.
A compounding strategy really is as simple as this, though how compounding works for different assets can be summed up in two main ways:
- If your asset pays interest, the interest you reinvest is added to the capital to attract more interest.
- If your asset pays dividends, those dividends are used to purchase more of the asset (for example, shares), and this increases the amount of the asset on which you will receive dividends in the future.
If your investment pays 5% in interest or dividends, by reinvesting this your invested amount increases and you earn more interest the next year. Each year you reinvest your interest or dividends, your earnings increase.
The difference is astounding:
- Without compounding, after 20 years you will have earned $1,000 in interest at 5%
- With compounding, your $1,000 will have grown to $2,653.30 – 65% more than the interest earned without compounding
What Are the Best Investment Assets to Achieve Compounding Returns?
Providing you reinvest the income produced, any income-producing asset can be used in a compounding returns strategy. For example, real estate investors who rent out properties can benefit from compounding returns if they reinvest their rental income into more real estate. However, more commonly you would invest in stocks, bonds or certificates of deposit to produce compounding gains. The best five are:
1. Certificates of Deposit
Certificates of deposit (CDs) are issued by banks. You can invest in a compound interest CD which pays a fixed interest rate, which is compounded at a set rate. The CD matures at a set date. When the CD matures, you receive the entire compounded amount accumulated.
2. Exchange-Traded Funds
An exchange-traded fund (ETF) is similar to a mutual fund. They invest in a basket of stocks that mirror an index on which the ETF is based. Where those stocks pay dividends, you would use those dividends to invest in more shares of the ETF. Thus, your dividend payments increase, and you reinvest these dividends in more shares.
3. Mutual Funds
Mutual funds invest in a basket of dividend-paying stocks and then reinvest those dividends into the basket of stocks held by the mutual fund.
4. Dividend Aristocrats
Instead of investing in mutual funds or ETFs, you might decide to invest in dividend aristocrats. These are stocks that have a history of increasing their dividends for at least 25 consecutive years. You might invest in single shares with this characteristic, or in an ETF whose constituents are dividend aristocrats.
For long-term investment toward your retirement, a 401(k) is a must. Its advantages include that you only pay money on the contributions and earnings when you withdraw the money, and many employers will match up to 100% of your contributions. Meanwhile, while your 401(k) remains intact, your investment benefits from compounding on the entire fund – including all contributions and the deferred taxes.
How Compounding Returns Could Help You Retire as a Millionaire
At the top of this article, I promised to show you how you could retire with a million dollars. Here’s where I stick to that promise. I’m going to assume you are around 20 years old and can invest only $100 dollars per month.
Thanks to the 401(k) Brokerage account, you could wrap the following investment in a pension savings account. However, for the sake of this example, we’ll keep it simple and imagine that you invest simply and directly.
Of course, this example is for illustration purposes only, and you should always take advice. Financial advice companies such as Personal Capital will help you consider your entire financial circumstances including your tax position before you invest.
Let’s say that you start investing with the plan to retire in 45 years, when you are 65. That’s not unreasonable, even if it does seem like a millennium away when you’re young.
If you kick off with an investment of $1,500 and then add $100 each month, you will have invested a total of $55,200. Instead of investing in a mutual fund, you could simply invest in an S&P 500 ETF. This replicates the performance of the S&P 500 Index.
Between 1973 and December 2018, including dividends the S&P 500 Index produced an average annualized compounded return of 10.09%. Without those dividends reinvested, the annualized return falls to 6.87%. The difference this makes is astounding. Running these numbers through the U.S. Securities and Exchange Commission Compound Interest Calculator, we find that:
- Without dividends reinvested, your fund value in 45 years could be $359,684,19
- With dividends reinvested, your fund value in 45 years could be $1,000,923,86
(Remember, this is only an illustration and historic performance does not guarantee future performance.)
With dividends reinvested and the power of compounding, you are more likely to be a millionaire at retirement. And not many people can say that.
Calculating Potential Returns from Compounding
When assessing potential returns from a compounding strategy, you don’t need to undertake a day of complex calculations. Fortunately, there are online compounding calculators.
For interest-bearing assets such as CDs, a simple compound calculator like this one at thecalculatorsite.com will do the trick nicely.
All you need to do is to:
- Select your currency.
- Input the initial (base) amount.
- Key in the interest rate.
- Key in the period of investment.
- Click on the compound interval (daily; weekly; monthly; quarterly; biannually; annually).
- Key in the regular deposit you plan to make.
- Then click on the ‘Calculate’ button.
For dividend-paying stocks or funds, the calculator at Investopedia is the best I’ve found. It works similarly to the interest calculator:
- Key in your initial investment.
- Key in your monthly additions.
- Key in the assumed dividend growth rate and the dividend yield.
- Input the number of years you plan to invest.
- Key in the assumed share price growth rate.
- Add your current age.
- Click on ‘Calculate’.
You’ll be presented with a table that details the fund value through to your planned investment period and beyond. This calculator also lets you adjust for inflation – a handy feature to compare future value to today’s spending power.
Why not give these calculators a try? It’s a bit of fun, and you will be able to see the real difference that compounding returns make to your investments.
How Can Investors Receive Compounding Returns?
Understanding how compounding affects your investment returns is one of the key pieces of knowledge for long-term investors to acquire. The longer the investment is held, the greater the effect of compounding.
By selecting an investment that is right for your objectives and risk profile, and then combining with a compounding strategy, it really could be possible to become a millionaire from a modest investment amount.
In this article, we have shown examples of how compounding affects investment returns. These are for illustrative purposes only and don’t constitute a recommendation to invest. You should always seek advice that is pertinent to you, your personal circumstances, your tax position, investment objectives, and attitude to risk. A financial advisor will help you do this.