THE COMPOUNDING
EFFECT

In financial terms, compounding is often referred to as the eighth wonder of the world. This is due to the profound impact it has on investments and the ability to turn modest savings into substantial wealth over time.

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Achieving your investment aims is reliant on more than just picking the right investments; it depends on how you manage those positions while they remain in your portfolio. Utilizing the effects of compounding to exponentially boost your returns over time can revolutionize your approach, and may even incentivize you to reconfigure your portfolio to optimize its compounding potential.

This article explores everything you need to know about compounding, and why many people consider it the secret key to successful investing. 

Understanding compounding

Compounding is a powerful investment technique that can result in your investment returns benefitting from an exponential “snowballing” effect. It involves reinvesting any returns over the lifespan of a position so that income received from it is transformed into additional investment capital. 

A virtuous circle forms where your capital increases in size, which increases the income you receive, which once again increases the capital, but by an even greater amount, and so on.

The basics of compounding

Compounding refers to the experience of earning returns from both your original investment and from any returns you have previously received from it. While the impact of compounding can be significant, the fundamentals of the approach are relatively simple. 

The compounding approach is commonly used to reinvest stock dividends, bond coupons, or capital gains on liquidated positions, but investment income can take various forms. For example, cash savings accounts also benefit from compounding. When interest paid is left in the account, it will be added to the overall total. The next time that interest is paid, it will be paid on that new total.

It is important to note that not all investment income is automatically reinvested. Enjoying the benefits of compounding might involve taking action to manually reinvest any income. For instance, certain stock dividends may (as a default) be paid out to investors in the form of cash, rather than reinvested into their holding. In this instance, an investor would need to contact their broker and opt to change the way that they receive dividends.

Compound interest vs simple interest

The terms “simple interest” and “compound interest” refer to two different ways of managing any investment income you might receive. While both forms of interest begin as credit issued to your account, the approach you take in managing this credit can have a significant impact on your overall investment returns.

Consider an example:

Take a savings account holding $100. If the interest on the account is paid annually at a rate of 5%, after 12 months, $5 will be paid out to the account holder.

In this scenario, if the simple interest approach is adopted:

The $5 isn’t reinvested, and the account balance remains at $100, so an annual interest payment of $5 will be issued in all subsequent years. After 10 years, the account balance will be $100.

However, if the compound interest approach is adopted:

The $5 is reinvested, increasing the account balance to $105. The following year, the interest benefits from a compounding effect, resulting in a payment of $5.25 ($105 x 5%). If reinvested again, this additional $5.25 further boosts the account to $110.25, and in year three, the account benefits from even higher interest ($110.25 x 5%). This pattern continues for as long as the position is held. After 10 years, the account balance will be $164.70.

The impact of compounding on investments

Adopting a compounding approach by reinvesting any investment income will increase the size of the capital you have invested. This creates a virtuous circle that can be particularly beneficial to long-term investors, such as those who are planning for retirement or adopting a FIRE investing approach.

Warren Buffett’s approach to compounding

Famed investor Warren Buffett is one of the greatest exponents of the benefits of compounding.

Our favorite holding period is forever.

Warren Buffett, Berkshire Hathaway Letters to Shareholders

While managing a diverse, but fairly standard, portfolio concentrated on household names and blue-chip stocks such as Coca-Cola and Bank of America, Buffett built his personal wealth to an estimated $132.8bn. Interestingly, 99% of Buffett’s total wealth was generated after he turned 50. 

The secret to his strategy? His decision to adopt a compounding approach to the returns made in his earlier years.

The way that Buffett grew his personal wealth is an example of how exponential returns can result in life-changing gains for investors who take a long-term approach.

Factors that impact the effectiveness of compounding

Compounding is a long-term approach, so it is crucial to continually monitor how real-world events influence the ongoing performance of your portfolio. To maximize your compounding returns, it is important to consider the risk factors that might impact the effectiveness of your strategy.

Factor	Impact
Market prices	Compounding relies on the value of the assets you hold going up in value.  Nothing is ever guaranteed in the markets, but the long-term trend in stock markets has historically been favorable to the compounding approach.
Instruments	Not all financial instruments generate a regular income, and those that do now might not do so in the future.  Dividends, for example, are paid at the discretion of a company’s management team and adjust over time according to the business’s performance.
Personal circumstances	A compounding strategy needs to be the best investment approach for your personal aims.  If your priority is receiving a regular income stream, or liquidating assets to finance your lifestyle, then compounding may not be the optimal strategy for you.
Taxation	Another factor to consider is how taxation will impact your investments. Tax terms and conditions differ across different regions, so it is important to consider the relative tax rates on, for example, receiving dividends as cash or stock. You may also want to factor in capital gains tax (CGT).  Reinvesting income rather than crystallizing a capital gain now might be beneficial at some point in the future — for example, when you retire and expect to have a lower personal tax rate.
Costs	Holding positions at a broker will incur some costs.  Time spent on ensuring that your preferred broker has competitive T&Cs can make a material difference to your long-term returns. You will also want to ensure that it offers markets in your target instruments and can be trusted.

Strategies to maximize compounding 

To make the most of compounding, it is essential to take a long-term view. This approach requires patience, especially once your capital is fully invested. Staggering your initial investments can be beneficial, aligning your average entry price with long-term market values, rather than buying at the peak of a short-lived bubble. 

Maintaining stability and consistency is key to compound investing. Keeping a cash buffer allows you to handle unexpected short-term demands on cash flow, without having to liquidate any investment positions.

Once you’ve established your strategy, choose assets that support a compounding approach. Popular options for compound investors include dividend stocks, bonds, money market funds, and real estate investment trusts (REITS). 

It is important to remember that the fundamental principles of investing still apply. Select assets that appreciate in value, and diversify across sectors, regions and asset types to manage risk and even out returns.

Compounding operates on the power of exponential growth. The longer you hold your positions, the greater the potential for significant returns as the snowballing effect gains momentum.

Final thoughts

While Albert Einstein is often credited with describing compounding as the eighth wonder of the world, the good news is that you don’t need to be a scientist to understand and incorporate the approach into your investment strategy. Investing with a degree of discipline and following simple and effective guidelines can help you to take advantage of the compounding effect on your way to achieving financial independence.

Visit the eToro Academy to learn more about the compounding effect.

Quiz

FAQs

How does compounding contribute to investment growth?

Compounding results in your total exposure to investments being maximized. As short-term income is reinvested, the next time income such as dividends are paid, you’ll receive a larger payment than if you hadn’t reinvested. As compounding generates exponential returns, it can be particularly beneficial if your investments are held long-term.

What factors can affect the rate of compounding?

The formula used to explain compounding won’t change over time, but the size of the variables involved almost certainly will. The amounts of regular income paid by assets in your portfolio may change due to macroeconomic factors, the underlying price of the assets you hold will vary over time, and you may decide to withdraw income to meet short-term demands. 

How can investors maximize the benefits of compounding?

Compound investing relies on discipline and patience. It also requires your initial asset selection to be well thought out, and there is a need to monitor positions on an ongoing basis and, where necessary, rebalance your portfolio.