The power of compounding

Investors’ decisions – both conscious and subconscious – have an important bearing on their long-term wealth. In this paper, we examine the power of compounding. 

Compounding isn’t a new concept – many of us will remember studying it back in our school days. Legendary scientist Albert Einstein famously called it ‘the most powerful force in the universe’, while American business magnate John D Rockefeller suggested compounding is the ‘eighth wonder of the world’.

These might sound like bold claims, but the power of compounding on an investment portfolio should certainly not be underestimated.

What is compounding?

In simple terms, compounding is the process whereby returns made on an investment are reinvested in order to generate subsequent returns of their own.

The concept of compounding is best illustrated using an example. Twins Annie and Vanessa both allocated $10,000 to the same interest-bearing investment on their 25th birthday. For simplicity, let’s assume the investment pays interest of 5% per year.

Annie reinvests all of her interest every year, while Vanessa banks the $500 each year and spends it on everyday living expenses. Let’s see how their investments had fared by their 45th birthdays.

Figure 1: Effect of compounding over 20 years

Annie’s investment value ($) 5% compound interest ($) Vanessa’s investment value ($) 5% interest ($)
10,000 10,000
Year 1 10,500 500 10,000 500
Year 2 11,025 525 10,000 500
Year 3 11,576 551 10,000 500
Year 4 12,155 579 10,000 500
Year 5 12,763 608 10,000 500
Year 6 13,401 638 10,000 500
Year 7 14,071 670 10,000 500
Year 8 14,775 704 10,000 500
Year 9 15,513 739 10,000 500
Year 10 16,289 776 10,000 500
Year 11 17,103 814 10,000 500
Year 12 17,959 855 10,000 500
Year 13 18,856 898 10,000 500
Year 14 19,799 943 10,000 500
Year 15 20,789 990 10,000 500
Year 16 21,829 1,039 10,000 500
Year 17 22,920 1,091 10,000 500
Year 18 24,066 1,146 10,000 500
Year 19 25,270 1,203 10,000 500
Year 20 26,533 1,263 10,000 500
Total value received 26,533 20,000

Source: CFSGAM. Figures used for illustrative purposes only.

Vanessa earned $500 interest each and every year for the 20 year period – a total of $10,000. Of course she still had her original $10,000 investment as well.

Annie, on the other hand, saw her investment grow to more than $26,000 by reinvesting her interest. The additional $6,000 she earned over and above Vanessa highlights the power of compounding. You can see from the table that Annie’s investment is now earning her $1,263 per year, while Vanessa’s investment is still earning her only $500. This differential would continue to grow over time if the sisters remained invested.

Figure 2: The effect of reinvesting interest

Annie’s investment

Vanessa’s investment

Source: CFSGAM. Figures used for illustrative purposes only.

Make compounding work even harder for you

The power of compounding can be magnified if you make small regular contributions to your investment. Let’s look at another example to highlight the concept.

Brothers Jim, Dan and Tom all decided to invest $10,000 in the same managed fund for 10 years. Over that time the fund returned an average of 8% pa.

Happy with his original investment decision, Jim did not make any additional contributions. Dan, the wiser brother, understood the effects of compounding and made additional regular savings of $100 per month. Tom – the wisest of them all – worked out he could afford to save an extra $200 per month and made sure he always contributed that amount to his investment. The difference in their investment returns over 10 years is startling:

Figure 3: Effect of compounding with regular contributions over 10 years

Initial     investment Monthly contribution Annual             return Value after 10 years
Jim $10,000 0 8% pa $21,589
Dan $10,000 $100 8% pa $39,602
Tom $10,000 $200 8% pa $57,614

Source: CFSGAM. Figures used for illustrative purposes only.

Source: CFSGAM. Figures used for illustrative purposes only.

Of course, the example is a stylised one. It ignores potential fluctuations in investment returns over the period, which would affect the three outcomes in reality.

These examples highlight how compounding and contributing regularly to an investment can have a major influence on investment performance. The long-term performance impact of compounding can be significant and must not be overlooked by investors. Perhaps Einstein and Rockefeller were right, after all.

Speak to your Shartru Wealth Management if you have any questions about compounding.

About Shartru Capital group

The Shartru Capital group is an Australian boutique investment and advisory firm. Shartru Capital is a significant investor in a number of businesses including Shartru Wealth Management.

Shartru Wealth Management is the financial advice and licensee business within the Shartru Capital group.

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Disclaimer: Published by Shartru Wealth Management Pty Ltd. ABN 46 158 536 871 AFSL 422409. The advice is general advice only and we have not considered your personal circumstances. Before making any decision on the basis of this advice you should consider if the advice is appropriate for you based on your particular circumstance