Guides, Resources & Education

The Miracle of Compound Interest

Learn why investing is the single most effective way to build wealth.

In this article I will discuss the magic of compound interest, how it works, and how you can make the most of it as an investor.

“Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t… pays it.”

Albert Einstein

Let’s say that you have placed $10,000 into a savings account that pays 5% interest on a yearly basis. This means that at the end of year one, you have $10,500, so you have made a $500 profit on your investment. This leaves you with two choices: you can either withdraw those $500 from the account or reinvest this sum. Let’s assume that Anna makes the choice of withdrawing the interest annually whereas John makes the wiser choice of reinvesting the interest (i.e., leaving it in the savings account) every year. After 15 years, Anna has made $17,500 whilst John has made approximately $20,879. John is significantly better off because he has earned compound interest throughout this period as a result of reinvesting the interest payments he has received whereas Anna was stuck earning simple interest. Time is a force multiplier when it comes to compound interest. To give an example of this, let’s assume that both Anna and John understand the gifts of compounding and therefore reinvest their interest. As above, both invest an original $10,000 at a 5% interest rate. However, Anna begins saving at age 20 whereas John begins saving at age 40. By the time Anna turns 50, she has made approximately $43,219 in contrast to John’s $16,289. Compound interest results in exponential growth, which is why this disparity would rapidly widen had Anna begun saving only 5 years earlier at age 15. Indeed, she would have made $38,871 more than John in this scenario, which is more than twice his entire savings, leaving her with a final $55,160. Here is the takeaway: start saving early.

Although I used a savings account as the above example – which lends money to the bank as other bank accounts do – compounding is also at work in the stock market. You can gain a profit from the stock market in two ways: capital appreciation and dividends. Capital appreciation refers to an increase in the value of an asset like a stock which can be sold for a profit. Dividends are a proportion of a company’s earnings – typically less than 5% – that are paid out to shareholders on a regular basis. Let us assume that you invest $10,000 into an index fund. An index fund is a popular, low-cost and low-maintenance investment vehicle that simply tracks a market index such as the U.S. S&P500. Tracking means that the fund buys up the exact same companies that make up the index and also mirrors the weightings assigned to each company (the % of the index that is represented by each company). The S&P500 – which generally represents the U.S. stock market – has returned an average of 8% annually since 1957. Assuming these historical returns remain true for the future, you would achieve the following returns at an 8% compounded annual growth rate (CAGR):

Years passedInvestment value ($) at 8% CAGR
514,693
1021,589
1531,721
2046,609
2568,484
30100,626
35147,853
Source: Author’s calculations

To truly visualise the exponential growth that occurs over time, look at the following graph:

Source: http://www.compounding-interest-calculator.com Note: You are technically not receiving interest when investing in the stock market, but the concept – you make a regular % of your investment – is the same.

At this point, you may ask yourself the following question: if I want to experience compounding in the market, wouldn’t I have to cash out the profits at the end of year 1 and then reinvest them into the same index fund? The answer is that you don’t have to do this because your investment will benefit from compound growth in that each year’s gain automatically becomes the benchmark for the next year’s gain. In the stock market, dividends typically produce a smaller profit than capital gains. This is because the dividend yield (dividend yield = the nominal dividend divided by the share price) of most companies is typically under 5%, and taxes must be considered, assuming the company pays a dividend at all. Nonetheless, reinvesting dividends also has a compounding effect which is actually very similar to the savings account example: you have the opportunity to earn interest on your interest if you reinvest a company’s dividends back into the company to buy more shares, which in turn leads to more dividends. This can sometimes be automated with a dividend reinvestment plan (DRIP). Most index funds also have a certain dividend yield. If the index fund is accumulating, which can often be seen by the letters ‘Acc’ in the fund’s title, dividends are automatically reinvested into the fund. If the fund is distributing, dividends are paid out to investors in proportion to their stake in the fund.

Compounding also works when you invest in individual stocks instead of funds. For example, say that you have bought $10,000 worth of shares in Company A and sell these for a 25% profit, netting you $2,500. As with the savings account example, you can either reinvest the complete $12,500 or withdraw the $2,500, which would leave you the original $10,000 to invest. Reinvesting the $12,500 into Company B for a hypothetical 15% return would net you $1,875, whereas investing only the original $10,000 for the same profit would win you $1,500. Again, this disparity is small at first but grows rapidly over time. Index funds are passive investments that are ideal for those who want to ‘let their money sit’ for years and compound on an annual basis. However, if you are an active investor you will often compound your money more frequently, which can boost your returns. Let’s say that you are a swing trader and you consistently make trades that you hold for weeks to months instead of years. In 2019, you started with $10,000 and made 4 trades, one each quarter. Each trade yielded an 8% profit and you always reinvested both the original sum and the profit into the next trade. Your original $10,000 would have compounded at 8% on a quarterly basis, four times, producing $13,604 at the end of the year. Meanwhile, an investor who had stuck with an index fund that returned 8% – thereby compounding only once – would have made $10,800. This example demonstrates that the frequency of compounding is another important variable, together with time.

Besides investing early and increasing the frequency of compounding, another way that you can turbo charge your wealth is by adding to your investments. Below, you can see the dramatic effect of adding $250 to your original $10,000 investment on a monthly basis. Instead of a final balance of $147,853, you would have $686,941 after a 35 year period.

Years PassedInvestment value ($) at 8% CAGR with $250 of monthly contributions
533,046
1066,910
15116,666
20189,774
25297,194
30455,029
35686,941
Source: http://www.compounding-interest-calculator.com

In summary, there are three lessons in this article: start saving early, make regular contributions, and if you want to take it one step further, increase the frequency of compounding. In other words, start shaping your snowball early, make sure you add as much snow to it as possible, and send it down a mountain – the longer it rolls, the better. Compound interest is a force that works in your favour, but it is up to you to implement it in the most effective way.

Processing…
Success! You're on the list.

Johan Lunau – 26/05/21

1 comment on “The Miracle of Compound Interest

  1. Pingback: What Works On Wall Street: How Simple Quantitative Strategies Outperform – Lucid Finance

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: