The Power of Compounding
One of the most compelling advantages about long-term investing is the effect of compounding. Truly a mathematical wonder, compounding effectively magnifies the returns of the investor, as long as the investment is performing well! It can be considered the 8th wonder of the world!
DISCLOSURE: THIS POST MAY CONTAIN AFFILIATE LINKS, MEANING I GET A COMMISSION IF YOU DECIDE TO MAKE A PURCHASE THROUGH MY LINKS, AT NO COST TO YOU. PLEASE READ MY DISCLOSURE FOR MORE INFO.
To truly take advantage of this phenomenon, the investor must hold his/her position for the long-term (at least a year or more). And in the case of investing money, the longer you hold a position that is generating above-average returns, the more profound the effects of compounding!
By investing money in the common stock of various companies, you should assume a perspective of owning the actual businesses themselves. An investment in common stock is, in fact, ownership in a publicly traded company, albeit partial ownership.
And if proper due diligence in the form of investment analysis is done upfront beforehand, you'll be knowledgeable about the business's operations, its management, culture, and the long-term drivers of its success. You will also have far more confidence to remain vested in excellent businesses that are poised to produce above-average returns over the long-term.
Having a long-term approach with your investment strategy is key to leveraging compounding!
Let's say you have $10K to invest. You do your research and financial analysis, and you decide on one particular investment in which to throw your entire $10K of investment capital. You end up holding that investment for a total of 5 years.
And let's say that, on average, that investment generates a 10% return annually. So, in Year 1, the investment produces a return of 10% of your $10,000 initial investment (or $1K). So, in Year 1 the initial $10K is now worth $11K.
But don't cash out that $1,000 profit in your first year! Don't spend that $1,000 profit from year 1! Instead, you retain your investment position. Now, instead of $10,000 working for you as an investment, you have $11,000 working for you in Year 2! Assuming a 10% return in the Year 2 coming, your profit will be $1,100 because your base has increased from $10K to $11K at the start of Year 2.
In Year 3, you now have $12,100 working for you as your investment base at the start of the year. ($10K initial investment plus your $1,000 return reinvested after Year 1 plus your $1,100 return reinvested after Year 2.
Again, assuming a 10% average return each year is produced by this investment, if this position is held and the annual returns allowed to be reinvested each year, following the 5 year investment period, your initial $10K investment will have grown to a very solid $16.1K.
$10K initial investment allowed to compound 5 years
Thus, after only 5 years, you have now taken a $10K investment and earned not a 10% return but rather a 61% return on your investment (ROI). This demonstrates the magic of compounding. Each 10% annual return is not cashed out or spent, but instead it is left parked in well-performing investment for a 5-year period. The effects of compounding go to work!
That's great news! But, wait... I've got even better news. If that same tactic had been able to play out on an excellent investment over 10 years rather than 5 years, then the effect of compounding would be even more profound!
$10K initial investment allowed to compound 10 years
Longer terms and higher average annual rates equal greater effects of Compounding!
If your investment consistently continues to produce solid returns, and you allow the effects of compounding to play out via long-term investing, the longer the term, the more powerful the effect of compounding and the greater push toward wealth creation!
If the average annual return is higher, then the more powerful the effect of compounding as well. Let's say our initial $10K investment over a 5-year period was with a company (or investment) that averaged an annual return of 20% rather than 10%. If we allow the annual returns to remain reinvested, the initial $10K investment has the ability to grow to nearly $25K in value! That's nearly $15K more than the initial investment...after just 5 years.
$10K initial investment allowed to compound 10 years at 20% annual return
If you're decent with using formulas, you can also calculate your compounded investing return using the following:
Compounding Formula - CAGR (compounding annual growth rate)
Using the most recent example above where we had an initial investment of $10K with an average annual return of 20% invested over 5 years:
- Vfinal = $24,483
- Vbegin = $10,000
- t = 5 years
- solving for CAGR, we get a value of 19.6% return
This can also be calculated in Excel
The appeal of compounding motivates us to stay vested for the long-term, rather than cashing out of excellent investments at the expense of redeploying that capital to lower-paying investments. It also negates the adverse effects of capital gains taxes, which reduce investor returns each time an investment is cashed out. It should be a key part of your investment strategy.
Investing returns are not guaranteed, and most of the time they're not steady. But if, on average, your investment is performing well year-over-year, staying vested for the long-term, reinvesting your returns, and allowing compounding to take effect can be super powerful!
When the value of the individual investments you own, like stocks and bonds, goes up (or down), that makes the balance in your investment account go up (or down). As long as you leave the difference invested, then your returns have the opportunity to compound over time. So getting started ASAP is a big deal — the higher your investment base and the longer your money’s invested (in excellent opportunities, of course), the more opportunity it has to compound over time.