In the world of investing, people always look for some kind of magic formula to unearth attractive investment opportunities. However, time and time again, this has proven to be a futile task. There is, however, one simple economic theory that can be looked upon as truly a magical formula. Regardless of how simple this might be, many investors turn a blind eye and eventually end up not reaping the benefits of compound interest. Because the word “interest” is used, many investors might falsely conclude that this has something to do with fixed-income products and not with other asset classes. However, this is far from the truth. The benefits of compound interest can be reaped by all investors alike, regardless of the asset class an investor might be specializing in. In this analysis, the concept of compounding will be introduced along with examples concerning different asset classes to showcase how an investor can use this to generate attractive returns on his/her investments.
What is compound interest?
This is an easy concept to grasp. When interest is earned for a single period, it’s a fixed return for an investor. Compound interest, on the other hand, is the interest calculated on previously earned interest. For example, a high-yield savings account with a quoted annual interest rate of 10% will generate a return of $100 at the end of the first year for an investor who commits an initial investment of $1,000. In the second year, however, the return would be calculated on the principal ($1,000) plus the interest earned in the first year ($100). Therefore, the total interest earned in the second year would be $110 ($1,100*10%). This process will continue as long as the money is kept in this account or until the end of the investment term. It’s relatively easy to figure out that the investor’s total return will be much higher than just 10% because of compounding interest.
Is compound interest a big deal?
The above example might prompt an investor to conclude that this is not a big deal. This, however, can be a very costly mistake. Even though the impact of compounding interest would not seem to be a big deal in the short term, the cost would only materialize in the long term. The best way to understand this is by looking at a practical example.
The below chart plots the ending value of an initial investment of $10,000 at a 10% annual rate.
As we can observe from the above chart, the longer an investor keeps his money invested, the higher the return would be. For instance, the ending value after 20 years reflects a holding period return of 572%. However, if the investment grew linearly over 20 years, the expected return would be just 200%. Evidently, compounding interest has increased the value of the investment by a staggering 372% at the end of the 20 years. This, exactly, is the magic of compound interest. An initial investment, regardless of its nominal value, will earn much more than the quoted rate of return because of this phenomenon.
As illustrated above, compound interest is, indeed, a big deal.
In the next segment, we will look at equity market investments and how compound interest applies to such investments.
How to use compounding interest in equity market investments?
Now that a reader has a clear understanding of how compounding works and the benefits associated with it, understanding how to apply those theories to stock market investments becomes simple. The key for an investor is to reinvest the dividends and other forms of shareholder distributions. This will enable the magic of compounding to work on their investments. The below chart should help investors gauge a measure of the massive opportunity cost of not reinvesting dividends.
If an investor initially invested in the broad market in 1993 and reinvested dividends, his investment would have grown more than 10 times the initial value. However, without reinvesting dividends, the return would have been much less at just 6 times. This is because of the compounding effect, or the lack of it for an investor who does not reinvest dividends. Today’s investors, especially the younger ones, often underestimate the dividends. Either they altogether forget about it or do not opt-in for reinvestment options. The majority of leading stockbrokers around the world provide Dividend Reinvestment Plans, commonly known as DRIPs. With just one click, an investor can decide to put dividends back to work and this couldn’t have been any easier than this.
A story of a washerwoman every investor should know about
If the above numbers have not yet convinced an investor, there’s a popular story of a woman who shot to fame thanks to the power of compounding interest. Oseola McCarty, who was born in 1908, worked as a washerwoman and worked in the same job for more than 60 years and lived in the same house ever since she was born. In 1995, Oseola donated a staggering $150,000 to the University of Southern Mississippi to establish a scholarship fund. Accounting for inflation, in today’s terms, the value of this donation comes to approximately $254,000. Leading local and national newspapers went in search of this woman to get more insights into how she amassed such wealth by working as a washerwoman that paid her the minimum hourly wage. She went on to reveal that she had been saving money from all her paychecks throughout her life and the magic of compounding interest had taken care of the rest. Even a very small, regular investment, can amass into a considerable amount of wealth if the investment is exposed to the compounding effect.
Start early to get the most of it
Finally, the importance of starting as early as possible has to be emphasized. The key here is to let compounding work for as long as we could. Once again, the best way to illustrate this is by using an example.
If an investor commits an annual investment of $5,500 at a rate of 7% per annum and continues for a certain period, the below is how the ending value of the investment would look like at different maturity levels.
The above illustration exhibits the importance of starting to invest as early as possible so that the money could compound over a longer time horizon.
There is no better way to end this analysis other than to quote the great Albert Einstein.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
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