The magic of compounding
Compounding is one of the most important concepts in investing and saving and must be fully understood to ensure high growth and sustainable returns. It sounds very impressive, but what does the term really mean and how does it affect you as an investor and saver?
Simply put, compounding is what happens when you take a number and increase that number repeatedly by a percentage. Each time you increase the number by a percentage, the number is larger because it was previously increased by that percentage. By way of an example, in a savings account if your initial savings amount is R100 and you receive 10% interest or R10.00 in the first year, taking advantage of compounding would mean reinvesting the interest earned so that your R110 earns 10% or R11 in year two. It means you will earn 10% each year on the initial R100 plus on the interest that has accumulated.
Let's examine this more closely and fully investigate the difference between fixed interest returns and compounding. Let's say you have R1 000 and will receive a 10% return each year on your money but you decide to withdraw your interest every year.
Fixed return of 10% per year:
Year 0 (when you start): R1 000
Year 1: 1 000 + 100 = R1 100
Year 2: 1 000 + 100 + 100 = R1 200
Year 3: 1 000 + 100 + 100 + 100 = R1 300
Year 4: 1 000 + 100 + 100 + 100 + 100 = R1 400
Year 5: 1 000 + 100 + 100 + 100 + 100 + 100 = R1 500
After five years you would have a total of R1 500 and a total return of R1 500 - R1 000 = R500 or 50%.
If you decide to reinvest the interest you will enjoy the full effect of compounding over the five-year period, keeping in mind that now you won't just receive 10% based on the original capital amount of R1 000, but you will also earn interest on interest.
Compounding interest at 10% return:
Year 0 (when you start): R1 000
Year 1: 1 000 + (1 000 x 10%) = R1 100
Year 2: 1 100 + (1 100 x 10%) = R1 210
Year 3: 1 210 + (1 210 x 10%) = R1 331
Year 4: 1 331 + (1 331 x 10%) = R1 464
Year 5: 1 464 + (1 464 x 10%) = R1 610
After five years you would have a total of R1 610 and a total return of R1 610 - R1 000 = R610 or 61%. The average return per year is 12.2% and not the 10% interest earned if you were to withdraw the interest. By allowing your money to compound over a five-year period it means that you receive an additional 11% overall and 2.1% per year. The difference in return widens even more over longer periods. This is the magic of compounding, and if you allow this to take effect in your investment portfolio you will increase your total return substantially over a long-term investment period.
For an investor there are two main streams where compounding comes into play:
1. Compound interest
Like the example above, this comes into play when you place your money in a savings account or money market instrument where interest is the return you receive. For compounding to take full effect, all interest returns should be left in the savings account to accumulate over a long period. Interest will be earned on the interest already earned as the capital base becomes bigger. By withdrawing the interest, the potential capital base is reduced, meaning less interest for the saver over time.
2. Compound returns
Compound returns relate to investing and investment returns. Unlike interest, investment returns can be volatile (move up and down). There is a higher element of risk when investing on the market; however, with that risk comes greater potential returns.
Like an interest instrument, an investor receives returns, but from two sources - dividends (the company shares profits) and capital returns (share price increases).
- Dividends represent a portion of a company's profits paid to shareholders. A dividend yield is the dividend received divided by the share price. If a stock has a price of R100.00 and pays a R5.00 dividend the company would have a 5% dividend yield. For compounding to take effect, that dividend of R5.00 must then be reinvested back into your share portfolio, either to buy more of the same share or another share.
- Capital returns represent the increase in a company's share price. If an investor bought a share at R100 and the share price were to increase to R110.00, the return on the share from a capital point of view would be R10.00 or 10%. Selling the stock and removing the R10.00 from your portfolio would eliminate the compounding effect on the R10.00 returns. To take advantage of compounding an investor would either hold on to the stock, or sell the stock at R110.00, realising a R10.00 gain in the portfolio, but then reinvest the full R110 back into another investment.
Both actions will have the impact of widening the investor's capital base on which he or she can enjoy higher dividends and capital growth.
The bottom line
"Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it." Albert Einstein
Nicholas Riemer
