Compounding Returns
One of the most important investment concepts to understand is the power of compounding returns. It’s a concept that was famously described by Albert Einstein:
“Compound interest is the eighth wonder of the world. He who understands it, earns it…
He who doesn’t…pays it.”
Put simply, compound returns include the returns both on your initial investment amount and on your investment earnings. Compound returns allow your investment to grow exponentially over time, like a snowball that gets bigger as it rolls down a hill and accumulates more snow. The power of compounding is best illustrated with examples.
Example 1
Let’s assume that you invest 15,000 into a managed fund and that it earns you an average annual return of 8% over 10 years. Let’s also assume that you reinvest all your returns to enable them to compound over the 10 years. The table below shows the compounding returns.
Year | Investment Value at Start of Year | Investment Value at End of Year | Yearly Investment Growth |
1 | $15,000 | $16,200 | $1,200 |
2 | $16,200 | $17,496 | $1,296 |
3 | $17,496 | $18,895 | $1,399 |
4 | $18,895 | $20,407 | $1,512 |
5 | $20,407 | $22,039 | $1,632 |
6 | $22,039 | $23,803 | $1,764 |
7 | $23,803 | $25,707 | $1,904 |
8 | $25,707 | $27,763 | $2,056 |
9 | $27,763 | $29,985 | $2,222 |
10 | $29,985 | $32,383 | $2,398 |
Total Compound Return | $17,383 |
Notice how the investment grows by an increasing amount each year, even though the rate of return is the same (8%). In year 1, the growth is $1,200, but by year 10, the annual growth is $2,398. That’s because the investment is compounding in value (i.e. getting bigger due to the reinvested returns). Over the ten-year period, the initial $15,000 investment more than doubles in value, increasing by $17,383.
Example 2
Let’s imagine that you let your $15,000 investment compound for 20 or 30 years (rather than 10), assuming that the same 8% average annual return is reinvested like it was in Example 1. The effect is even more dramatic, as shown in the following tables.
Investment Value at Start of Year 10 | Investment Value at End of Year 20 (at 8% Compound Annual Return) | Total Compound Return between Years 10 and 20 |
$32,383 | $69,912 | $37,629 |
Investment Value at Start of Year 20 | Investment Value at End of Year 30 (at 8% Compound Annual Return) | Total Compound Return between Years 20 and 30 |
$69,912 | $150,935 | $81,023 |
The $15,000 initial investment will have grown to $69,912 at the end of year 20. It will grow to $150, 935 if you do the same over 30 years! This illustrates the power of compounding over time. The longer you can let your investment compound, the faster it will grow for you. This escalating growth at 10, 20 and 30 years is shown in the chart below.
Example 3
Now let’s imagine that you can add regular smaller amounts to your initial investment, say $100 per month, and that you earn an average annual return of 8% as in the previous two examples.
Adding regular smaller contributions to your initial investment makes the compounding effect even stronger, as shown in the following tables.
Investment Value at Start of Year 1 | Annual Contribution | Total Amount Invested Over 10 Years | Investment Value at End of Year 10 (at 8% Compound Annual Return) |
$15,000 | $1,200 | $27,000 | $51,589 |
Investment Value at Start of Year 10 | Annual Contribution | Total Amount Invested Over 20 years | Investment Value at End of Year 20 (at 8% Compound Annual Return) |
$51,589 | $1,200 | $39,000 | $132,804 |
Investment Value at Start of Year 10 | Annual Contribution | Total Amount Invested Over 30 Years | Investment Value at End of Year 30 (at 8% Compound Annual Return) |
$132,804 | $1,200 | $51,000 | $313,072 |
The escalating growth at 10, 20 and 30 years due to the power of compounding is shown in the chart below. The bottom line is that the earlier you can start investing, the better. It will give you more time for the power of compounding to work for you.
How we can help
At Qi Wealth, our experienced, expert team of advisers can help you to harness the power of compounding returns and make smart investment decisions. We’ll take the time to understand your individual circumstances so that we can provide you with the best possible advice. We develop long-term, trusted relationships with our clients.
Contact us today to find out how we can help you!