Compounding is defined as the process of generating more returns on an asset’s reinvested earnings. In plain English? Compounding means that you can earn more money by reinvesting the money you’ve already made from your investments. Sounds simple enough, right? That’s the thing – it is.
To make compounding work, you will need only two things: an investment portfolio and time. With these two components, you could achieve some amazing results. Let’s begin by looking at the concept of compounding through an easy example, so that you can see its value in real terms.
We will start by looking at the value that reinvesting plays on a portfolio. Let’s consider an investor, Lucy, who puts $100 into an investment account and chooses stocks that make returns at the average market rate of return, usually estimated to be between 5-7%. We can be more conservative in this example and use the 5% figure to calculate the value of her portfolio over time. With that, if this investor keeps the $100 in her account for one year, she would have $105 in her portfolio at the year’s end. So, in one year, this investor would have made a $5 profit on her investments.
Now, because she has reached the end of her first year of investing, our investor decides to think about the best possible strategy for her portfolio. Ultimately, this investor has two different options. We will now follow her journey into these two separate scenarios. In Scenario 1, our investor is thrilled with her $5 profit and withdraws that money so that she can spend it. After celebrating her newfound investing success, her account is left with the initial $100, which she will leave to face the market again for another year. Assuming her investments perform about the same as the past year (of course, an assumption for the sake of this example), she comes out of year two, again with $105. So, she has again made a $5 profit from her investments. In the grand sum of her investments over two years, she has made $10 – not too shabby! If she continued in this pattern of making a $5 return each year and removing that extra money from her account at the end of the year, she would make $50 after 10 years of investing (found by multiplying her $5 profit from each year by the 10 years).
Scenario 2 plays out a little bit differently, though. In this scenario, our investor chooses not to withdraw her $5 return at the end of her first year of investing. Instead, she decides to reinvest that money in other securities that she believes will succeed. Again, she makes a 5% profit on her portfolio; but, this time that 5% return leaves her with $110.25 after her second year – because she started her second year with $105 instead of only $100. This means that she has made $10.25 on her investments in two years, instead of the $10 she made in our previous scenario. While that one quarter may not seem like such a big deal just yet, it will continue to grow over time with the rest of her investments and could make a big difference in the long run. For example, after 10 years of reinvesting her returns from her initial $100, our investor would have $162.88, or a $62.88 profit. That is $12.88 more than she would have made in our first scenario, by not reinvesting her returns for 10 years. To put this into more scalable terms: this investor made a return that is 25% more than she would have made over the same 10-year period if she had not reinvested her profits.
From this example, we can certainly see the value that time plays, as well. After only two years in each scenario, the difference between the investor’s possible returns was tiny – only 25 cents. But, after 10 years with compounding, the difference was a lot greater (more than $12).
What big lesson can we take away from all of this? The earlier we start investing, the more time we give our investments to grow. Further, the longer we leave our returns in our portfolios to make their own returns, the more total returns we will see in the long run. So, for all of the younger investors out there that may be nervous to try their hands at investing – what do you have to lose? All you need is time and an average investment portfolio – let the power of compounding do the rest.