Compounding is a powerful investing concept, and without it, you won't be able to build wealth. But how does compounding work, and how can you use it to your advantage?
To those who don't understand it, the concept of compound interest can appear like magic. But once you understand the power of compounding, it will completely change your view on money. Thanks to the power of compounding, the value of your savings and investments is continually increasing, thereby allowing you to grow your wealth.
Let's explore the power of compounding and how you can apply it to your investments in this chapter.
The power of compounding is probably the most powerful tool you have at your disposal to build up your wealth and become financially independent.
Compounding happens when the value of your asset increases exponentially. The increase of value happens on top of your initial investment plus the previously accumulated value. As a result, the value that is being compounded increases steadily, and therefore each value increase gets more significant over time.
The power of compounding is a fundamental concept in investing. However, while most people associate the idea with compound interest that you receive on your savings account, it can be applied to various asset types, like stocks.
Let's look at how the concept of compound interest is applied to your savings account, bonds, and stocks.
When you save money in a savings account, money market account, or certificate of deposit, you will typically receive interest from the bank where you keep the money. Banks pay you interest because they can use your money to lend it to other customers. These customers then pay the bank interest, and, in return, the bank pays you part of that interest for lending them your money. The bank then makes a profit from the difference between the interest they received and the interest they paid you.
Most of these bank accounts pay you interest based on the current value of your account. Therefore, keeping the received interest in your bank account will slowly compound your money with each interest payment. The frequency of interest payments often varies between different accounts and banks. Usually, interest is paid either quarterly, bi-annually, or annually.
You decide to save $100 in a savings account with an annual 10% compounded interest rate. After the first year, your savings will be worth $110 as you received $10 in interest. In the second year, the value of your savings increased to $121. The increase comes from $11, which you received in interest based on your previous balance of $110. In the third year, you received $12 in interest bringing the total value of your savings to $133. Finally, after 50 years, your savings will total $14,832 as the interest keeps compounding.
Unlike your savings account, bonds typically do not pay out compound interest. Instead, they pay out so-called simple interest. While compounded interest is paid on the initial value plus accumulated interest, simple interest is only paid on the initial value of the bond itself. Therefore, the value of each interest payment stays the same as in previous payments and does not increase over time. However, you can still benefit from compounded interest with bonds if you reinvest the interest you received and purchase new bonds with it.
Alternatively, you invest in accumulating bond mutual funds or bond exchange-traded funds that will reinvest the interest for you. Therefore, if a bond pays out interest, the investment fund will use the interest to purchase new bonds, which will increase the future interest payouts. The benefit of investing in these investment funds is that you will not be liable for capital gains taxes on the bond's interest as it has never been paid out to you but has been reinvested by the fund instead. However, the downside is that you will have to pay management fees to the management of these investment funds.
You decide to purchase a five-year government bond with an initial value of $1000 and an interest rate of 10%. The bond will pay you interest once per year. As the government bond pays you simple interest, you will receive fixed interest payments of $100.
Therefore, after five years, you will have received $500 in interest payments from the government. You would have received roughly $610 in interest if the bond had paid out compounded interest instead.
Unlike savings accounts or bonds, stocks do not pay you interest. Therefore, rather than relying on interest to achieve compounded growth, you have to rely on dividend payments and the value increase of your stock holdings.
Dividends are the company's income that is being paid out to its owners. Many (but not all) stocks will pay their owners quarterly or annual dividends. However, unlike the interest you receive on a savings account or bond, dividends have to be agreed upon by their owners whenever the company decides to pay them. Therefore, dividends are much less predictable than interest payments. When a company is doing well, it might choose to pay out a higher dividend. However, in bad times it might pay none at all.
To achieve compounded growth with dividend-paying stocks, you should look for a long history of frequent and stable dividend payments. Once you find these stocks, you should reinvest the dividend you received and purchase more stocks of the same company. By reinvesting dividends, your holdings will slowly increase, and therefore you will receive larger dividend payouts. When you consistently follow this approach for a long time, you will experience compounded growth of your money.
The second way to achieve compounded growth through stocks is to find companies with stable earnings growth. As the earnings of these companies grow, so does the overall value of the stock. Therefore, if you can buy and hold stocks with stable earnings growth, the value of your stocks will increase in the long run.
However, you have to consider that the value growth of stocks is much less predictable than the growth of compound interest. For example, you might experience only an average return or even a loss in some years, while you will see significant gains in others. Therefore, it is crucial to keep holding your stocks and not sell them prematurely. The returns will average out in the long run, and you will see compounded growth.
As Albert Einstein famously pointed out, the power of compounding can work both for and against you. On the one hand, you can achieve the exponential growth of your capital by investing or lending it out. On the other hand, you have to pay compounded interest when borrowing money from others. Over longer durations, the accumulated interest on your borrowed money can often outsize the actual loan amount.
“Compound interest is the eighth wonder of the world. He who understands it, earns it […] he who doesn't […] pays it.”
To apply the power of compounding to your investments, you should follow a few rules:
Unfortunately, many beginner investors start investing in an attempt to get rich quickly. However, to invest successfully, it is crucial to invest with a long-term time horizon. While compounding is a powerful tool to accumulate wealth, it has the downside that it takes many compounding periods to achieve a meaningful result.
“The first rule of compounding is to never interrupt it unnecessarily.”
While the early results of compounding might not be impressive, they will get better and better over time. To see noticeable exponential growth, you need to invest large amounts of money. Unless you're lucky and have been born rich, it will take years to build up sufficient investments. However, this shouldn't discourage you. The earlier you start to invest, the longer you stay invested, and the more money you have invested, the more compounding returns you will receive.
It may take some time to see noticeable compound returns. However, there are ways to accelerate the exponential growth of your money.
First, you should reinvest all income that is being paid to you from your assets. This includes dividend payments from your stocks and interest payments from your savings account, money market account, certificate of deposit, or bonds. By reinvesting these payments, you increase the amount of your invested capital and, therefore, the amount of future payouts.
Similarly, you can further increase your future payouts by making regular contributions to your savings and investments. Ideally, you set aside a fixed amount of money for every paycheck you receive. The more you can afford to contribute now, the sooner you will see significant compound returns on your initial investment.
Finally, you must avoid scenarios where the power of compounding works against you. For example, it might be tempting to take out loans to purchase goods that provide short-term satisfaction or to use leverage to achieve higher investment returns. However, all borrowed money must be paid back, usually with compound interest.
As a result, your debt can work against you and negate all efforts to build your wealth through the power of compounding. For example, suppose you have to pay 8% of compounded interest on a loan. In that case, you have to make an investment return of at least 8% plus the current inflation rate just to break even. Therefore, it is best to avoid all avoidable debt and use debt carefully.
Now that you know about the power of compounding, it is time to learn how you can calculate its effect. In general, there are two essential formulas you should know about.
The first one lets you calculate how much your money will be worth in the future based on a given interest rate. The second formula will tell you how much your money was originally worth based on the future value of your money.
The future value of your money is the value it will have in a given amount of years based on a fixed interest rate. The formula does not consider variable returns like those you would achieve using volatile investments, like stocks. Therefore, it works better for stable investments with fixed interest rates, like bonds or savings accounts.
You can calculate the future value of your money using the following formula:
The formula assumes the following inputs:
The present value is the value that your compounded future value originally had. Therefore, the present value is the inverse value of the future value described previously.
You can calculate the present value using the following formula:
The formula assumes the following inputs:
The rule of 72 is a mathematical formula that helps you to quickly judge how long it will take for your money to double in value with compounded interest. You can calculate the time to double your invested capital by dividing 72 by the annual interest or return that you expect to receive for your investment.
While the rule is not 100% accurate, it can provide a rough estimate of your potential return. However, it can also be used to calculate how long it will take to double your credit card debt or when your money will halve in value due to inflation.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.