How can investors receive compounding returns? Compounding returns help you to achieve your retirement goal early. Compounding is an asset’s ability to generate returns. These earnings are then reinvested to produce their returns. In simple words, compounding means making returns from previous returns.
The law of compound earnings is nature’s force. Hence understanding this concept is crucial to any investor’s success. This’s how the wealthy keep getting wealthier.
Simply explained, the law of compound earnings says money builds more money
Einstein claimed, “Compound interest (CI) is world’s 8th wonder.” Ben Franklin added, “Money can create money, and its product can create more.” Charlie Munger, Warren Buffett’s partner, echoed this sentiment about money. He said, “never disrupt it needlessly.”
See the law of compound earnings as a snowball rolling down a hill. As it rolls down its weight increases which makes it speedier. This keeps on increasing its size again. A long hill and wet snow are conditions turning a snowball into a big boulder. Snow moisture is an investor’s rate of return. The hill size is investor’s time horizon.
What Is Compounding?
Compounding refers to the process where an investment grows in value as returns on the investment earn interest over-time. Such exponential growth happens as the total growth of an investment and its principle earn interest. This is different from linear growth in which only the principal earns money every period.
The magic of compounding changes your money into a powerful income-producing tool. Compounding generates returns on the earnings of a reinvested asset. It needs two things to work: time and reinvesting earnings. The more time there’s with your investments, the more you can speed up the earning potential.
This principle is also called compound interest (CI). Say, an investment of $10,000 in Firm X earns 20% during the first year. Now, the total investment is $12,000. Next, suppose that in the 2nd year, the investment earns 20% more. Hence, the amount of $12,000 will earn 20%, making the value $14,400 and not $14,000. This additional $400 increase is because of the $2,000 earning of 1st year also increasing at 20% in 2nd year.
Impact of Compounding on Future Value
When compounding happens on an investment, the interest rate determines the future value. It is also important in determining the number of times compounding happens per period. Suppose a 1-year time frame. Higher compounding periods lead to higher final future value of an investment. Hence, two compounding periods a year are better than a single period. Again, four periods each year are better than two. The general formula to calculate compound interest is:
FV = PV x (1 + ( i / n)) ^ (n x t)
FV = future value
PV = present value
i = the yearly rate of interest
n = number of compounding periods year
t = number of years
Provided this formula, suppose that a $2 million investment earns 20% every year. Hence, the future value depending on the different number of compounding periods will be:
Annual compounding (n = 1): FV = $1,000,000 x (1 + (20%/1)) ^ (1 x 1) = $1,200,000
Semi-annual compounding (n = 2): FV = $1,000,000 x (1 + (20%/2)) ^ (2 x 1) = $1,210,000
Quarterly compounding (n = 4): FV = $1,000,000 x (1 + (20%/4)) ^ (4 x 1) = $1,215,506
Monthly compounding (n = 12): FV = $1,000,000 x (1 + (20%/12)) ^ (12 x 1) = $1,219,391
Weekly compounding (n = 52): FV = $1,000,000 x (1 + (20%/52)) ^ (52 x 1) = $1,220,934
Daily compounding (n = 365): FV = $1,000,000 x (1 + (20%/365)) ^ (365 x 1) = $1,221,336
This compounding process has a limit too. Based on calculus, it’s called continuous compounding. It’s computed as:
FV = PV x e ^ (i x t),
e = the irrational number 2.7183.
In the example given above, continuous compounding makes the future value:
FV = $1,000,000 x 2.7183 ^ (0.2 x 1) = $1,221,403
How Can Investors Receive Compounding Returns?
Your task as an investor is to pick a risk level you can live with. Accordingly, you should structure an effective portfolio. Then, you should let the magic of compounding work on its own.
A longer hill is a difficult thing to get. But the choice of your investment will decide if the snow is wet. Investment fees, taxes, and underperformance disturb the law of compound earnings. These factors decrease your returns and dry your snow.
If you use funds traded on an exchange, your fees can reduce by 80%. This helps you sustain more from your returns. But remember one thing. Trading ETFs regularly can raise the tax burden. It’ll eat a slice from the snowball as it goes down the hill. So, the less you trade, the more you can defer tax liability. This will lead to more money snowballing every year. Once you’ve had your ETFs for one year, small earnings from re-balancing get taxed. The rate of interest is the lower long-term capital gains rate. Plus, as most ETFs track indexes, you’re unlikely to lose anything trusting on investment plans that don’t pan out.
The law of 72 will help you understand compounding. Divide the annual return by 72. The outcome is the number of years your money will take to double. The money will increase in 12 years @ 6% rate of return. It’ll double every eight years @9%. This means if your age is 40, an investment of $100,000 @6% will double twice to become $400,000. You’ll be 64 years old at that time. At 9%, it’ll double thrice to $800,000. If you get a steady higher return rate for several years, your money may turn into a fortune. But, you need to learn to live with some fluctuations.
Inflation is the dark aspect of the principle of compounding. It decides how your savings decrease with time. Supposing an inflation of 4% p.a., with the law of 72, means every 18 years the price doubles. Hence, you can only buy half of your money now than what you did before. Saying that two decades after your retirement, your money will lose half of its purchasing power.
The principle of compounding is a slow yet strong tool. It’s an invisible force you can’t neglect. Because of how it works with inflation, your money will lose its worth by 50% in 18-24 years. But, try to lessen your taxes, fees and increase the returns by even 2-3% p.a. This way your savings will double in 24 years.
Key to Retirement Success Is Compounding
You may wonder what is the most potent force in your retirement plan. No, it’s not tax deductions, not stock market and not even more savings. The recipe for retirement success is only compounding.
Yes, saving more is important. You can’t protect your retirement on no basis. Saving automatically and early is a significant advantage
Keeping more of your pay-check by careful tax management helps too. Investing money in 401(k) will reduce your tax liability today. Saving more through Roth IRA will help you negate the impacts of taxes during retirement. Yeah, you won’t stop paying taxes even after you retire. You’ll also pay tax on Social Security.
But, many people think that the key to being successful at retirement is in a quickly growing stock market. Stocks are essential for your portfolio. But waiting for a perfect time the bullish market is not a smart way to approach your retirement goals. People nearing their retirement have learned this lesson.
There’s a Pew Charitable Trust report which shows how the younger generation is not happy about retiring on time. Their concern lies over the erratic performance of the stock market during recent years.
Excerpt from the Pew Research Center:
During 2009, the “Gloomy Boomers” in their mid-50s were the most concerned about outliving their savings. Today, retirement concerns are highest among adults who’re in their late 30s. Many of these are the elder sons/daughters of the Baby Boomers. The Pew Research also analyzed the Federal Reserve Board data. It unveiled that this is the same age group which suffered the most significant losses in household income in past years.
The new Pew Research study also makes some stark revelations. It unveils that among people aged 36-40, 53% are not confident that they’ve enough savings to sustain through retirement. On the contrary, just 34% of the ones aged 60-64 express similar express. An even smaller percentage (27%) of the ones aged 18-22 agrees with this.
The problem with the stock market approach is that it makes the same mistakes which the Baby Boomers made. They relied too much on luck to retire on time. The recipe for retirement success is to have a plan, and not a bet which works out.
This plan can be in any form. From a detailed one to a simple one. But, the bottom line is to have a target/number you think you can achieve during your employment. As difficult as it may be, reaching the number is the easier part.
Instead, what few people recognize is that compounding is the primary key to retirement success. Compounding makes your retirement happen.
The recipe for retirement success via compounding is to have two main things – time and income.
Why do you ask? Due to compounding. Let’s look at it more directly. If you save one dollar and invest it, it will grow, right? E.g., you receive a return of 7%. After one year you’ve $1.07.
It’s not a big deal. But first, understand the nifty part. Now, rather than working for money, your money starts working for you. Those additional 7 cents are also growing. Let it remain for 30 years compounding it quarterly. In the end, you’ll have $8.02.
Eight dollars! “So what?” you may claim. Well, let’s say you kept aside $20,000 at the age of 35 and didn’t add anything to it. Your money grows at 7% in 30 years. At first, slowly. During the 10th year, the sum is something over $40,000.
Now you may think it’s nice. I got double the amount with no effort. Wait, for it. At the 20th year, the sum has again doubled to $80,128.
Wait for ten more years and see the magic of compounding. The small seed you had sown when you were 35 has now become a mighty oak. It will double to $162,384 in the 30th year. Go for ten more years. And, yes you got it right, it will again double to $321,024. The cycle goes on and on.
Retirement Success Made Easy
Remember, you saved the first $20,000 once and didn’t add even a dime. Nonetheless, saving carefully on a periodic basis is critical to retirement success. This is how you convert hundreds of millions of time.
So, yeah, the key to being wealthy at retirement is saving. Plus, you also need to defend your income from taxes via a tax-deferred savings plan. But, it’s also sheltering your retirement with a safe, steady plan which will increase your savings.
How Can Investment Accounts Receive Compound Returns?
1. Bank Accounts
Bank accounts are seen as classic compounding vehicles. One of the main features of most savings accounts is their interest. Their interest is usually higher than the interest you get on checking accounts. In fact, many checking accounts don’t even pay any interest.
You can even get CI in certificates of deposits and money market accounts.
2. Some Bonds
Most bonds pay a defined interest sum. But some, like zero-coupon bonds, have compounded growth. A typical bond has you paying the bond’s face value which could be $10,000. And then it collects regular interest before receiving the bond’s face value during maturity. But, with a zero-coupon bond, even if it’s face value is $10,000, you’ll pay lesser for it. Maybe $9,500. You’ll get no interest payment, but during maturity, you’ll get $10,000 and not $9,500. This difference is the compounded value of interest payments.
3. Some Non-Interest-Bearing Investments
It’s crucial to know that compounding works in situations besides interest too. E.g., think of stock which pays dividends. If you plow-back the dividend into shares of more stock, then the shares will grow also. This way they’ll kick out the dividend payments by themselves. Such reinvestment can aid the faster growth of your portfolio. If you don’t reinvest that amount, then the portfolio will not grow faster.
Compounding can even help you estimate your project’s performance. This will be beneficial for financial planning purpose. Say, you have a portfolio of $100,000 in stocks. You hope that it will increase yearly by 7% over the next two decades. Run the numbers, and you can expect to have $387,000 in next two decades.
Targeting for compounded growth in your portfolio is wise. Bank accounts will not give you quick growth due to the existing low rate-of-interest environment. But don’t write them off always. There’ve been many years with rates-of-interest in meaningful ranges. In some years there’ve also been double-digit interest rates. Plus, remember that stocks can also provide you compounded growth.
How Can Mutual Funds Receive Compound Interest?
To sum up, the charm of compound interest is the principle of interest making interest. On the contrary, simple interest works on the original principal balance. It doesn’t consider the gains made from interest.
Mutual funds are one of the most straightforward means to get benefits of compound interest
Choosing to reinvest dividends from MFs leads to buying more shares. Hence, over-time more compound interest accumulates. This cycle of buying more shares will help investments grow in value.
Compound Interest Adds up Quick
E.g., consider a mutual fund opened with an original investment of $5,000. You did a yearly addition of $2,400. With an average of 12% yearly return of 3 decades, the future value of the investment is $798,500. The compound interest refers to the difference between cash added to an investment and its real future value. In this case, by adding $77,000, or a cumulative addition of $200pm over three decades, CI is $721,500. This CI is on the future balance.
To Conclude, All Investors Can Receive Compound Returns
You don’t need to be wealthy for CI to work for you. All you need is the understanding of time-value of money and begin investing early. The principal is same no matter you invest $20 million or $200. By adding interest you earn to the principal, the value increases at an increasing rate. Compound interest is a straightforward and useful concept in finance which can benefit an investor.