We compared the investment return concept of simple versus compound in Compound Returns. We saw how compounding may actually result greater asset growth than that from an investment alone.
Today we examine some very important investing lessons resulting from the power of compounding. If you understand and adhere to these lessons, you will improve your investing results and wealth accumulation.
For all the lessons below, we shall use the same basic data from the following example:
You invest $1000 in a bond fund earning a 10% rate of return, compounded annually. Earned interest is automatically reinvested in additional fund units. Changing interest rates, capital gains or losses, taxes, and transaction costs are ignored. After 10 years your investment will be worth $2594 ($1000 initial investment, $1000 interest on your capital; $594 interest on compounded reinvested income).
Assuming all other variables remain unchanged, here are the key investment lessons:
The longer the investment period, the greater the impact of compounding.
Time is a crucial component for compounding.
In our example, after 10 years your initial investment grew to $2594. Not bad. But if you leave that money alone for 50 years, your one time investment of $1000 grows to $117,391. Impressive.
Over that 50 years, you only earned $5000 (50 years X $100 per year interest) in simple return. The rest of the increase is due to compounding. That is, interest earned on interest.
The farther out the year, the greater its impact of compounding.
After 10 years at 10%, you end up with $2594.
If you need the cash after year 9, you only get $2358. Not that bad, but you lose more than just the $100 simple return in year 10. You also lose an extra $136 in interest due to lost compounding. Not great, but not too bad.
However, if you need the money in year 49, you only receive $106,719 versus the $117,391 if you held out until year 50. That lost $10,672 is huge. And almost all of it reflects the compound interest effect over the years.
The longer you can keep money compounding, the greater the incremental impact. Think of that before accessing your tax-free or tax-deferred investment plans.
The higher the rate of return, the greater the impact of compounding.
All else equal, the rate of return has a big influence on performance.
At a 10% compound return, a single $1000 investment grows to $2594 in 10 years and to $117,391 in 50 years.
Had you found an extra percent return, the impact is noticeable. Over 10 years, you end up at $2839, an improvement of 9.5%. Over 50 years, you get $184,565, a change of 57%.
A big concern with investment product fees that reduce net returns. If you own a mutual fund that charges 1.5% annually, that 10% return nets to 8.5%. Your bond fund now will be worth only $2261 in 10 years and $59,086 in 50 years.
Over 10 years that “fee” to the fund company reduces your wealth $333. Over 50 years, $58,305. And that is all based on you investing a mere $1000. Think of the wealth accumulation differential if you invest a $100,000 or more.
That is a lot of money you are giving away to the mutual fund company in exchange, I expect, for “free advice.” Let your wealth compound in your account, not in the fund company’s coffers.
The more periods in a year an investment compounds, the greater the impact of compounding.
The greater the periods, the more times interest will be calculated, the sooner the next round of compounding can begin.
May sound odd, but think of a home mortgage. The more payments made in a year, the quicker the principal falls. Even if the aggregate value of payments in a year is equal.
In our first example, interest was compounded on an annual basis. That gave us the end values of $2594 over 10 years and $117,391 over 50 years.
Compounding monthly, our investment grows to $2707 in 10 years and $145,369 in 50 years.
And daily compounding results in asset values of $2718 in 10 years and $148,312 in 50 years.
Exactly the same investment with the same time frame. Yet just by accelerating the compound periods you are able to increase your overall return.
The less your costs, the greater the impact of compounding.
Costs such as taxes, sales commissions, management fees, and transaction costs, all reduce your monetary return. Less return translates into less money being reinvested. That significantly affects the power of compounding over time. Be very aware of this.
We saw the impact of fund fees above. Taxes are another huge area to try and minimize and/or defer.
Without being too detailed, let’s assume you pay a reasonable 30% tax rate on your earned income. So for each $100 in interest you earn, only $70 can be reinvested. In essence, your annual return has fallen to 7% from 10%.
In our example, your $1000 would only grow over the 10 years to $1967 and not $2594. The government took $300 in taxes, but you also lost $327 in compound interest.
Annoyed? If so, stop reading.
Over 50 years, you only finish with $29,457 and not the $117,391 before tax.
Take advantage of available tax-free and tax-deferred investment accounts.
The same holds true for other costs, such as management fees and transaction costs. Money paid to others will not accumulate on your behalf. 1% fees here or there may seem like nothing. But as we saw above, they can be massive over time.
We will look at ways to minimize costs at a later date.
Conclusion
The younger you begin to invest, the longer the time horizon until retirement. This is great for compounding returns.
Being younger also allows you to take on higher levels of risk in an attempt to earn better returns. Again, something very useful for compounding growth.
The later in life you begin to invest, the more at a disadvantage you will be. But the longest journeys begin with a single step. You just may need to allocate more to your portfolio to offset the lesser compound returns.
Additionally, as you can see from the lessons, minimizing your investment costs is crucial to long term growth. We will look at cost minimization strategies as we go along. But the keys are to avail of tax-free or tax-deferred savings plans and to minimize investment expenses paid to your advisors, fund managers, banks, etc.
Always let your wealth compound on your behalf. Not someone else’s.
I hope this clarifies the concept of compound interest and that you begin to take advantage of it.
Next up, realistic examples on how these compounding lessons impact wealth accumulation.
