feature image

The Basics of Investing: Compounding - Big Sky Financial Solutions

The Basics of Investing: Compounding



To be a successful investor, you need to be patient. You need a long - term view, clear goals and some good financial advice. That way, you’re more likely to make sound decisions, not impulsive ones.

This is the first in our new series of articles about the investment basics, those key principles you should understand - and follow – if you want to be a successful investor.

One of those principles is compounding. Put simply, it means earning interest on the interest you've already earned from your investments.

The marvel of compounding


When asked what he thought was the most powerful force in the universe, Albert Einstein reputedly answered, "compound interest". Whether Einstein actually said this or not can't be verified, but we think he was right on the money, so to speak.

By keeping any returns you make on your investment in that investment you can also gain on any potential returns on those returns.
This is best explained with an example. Let’s say you received a work bonus in 1996 of $10,000 and invested this for 15 years in a fixed interest fund that paid 15% per annum. You have the choice of having the annual interest paid into a savings account or reinvesting it back into the fund.
Here's the difference between these two options at the end of the 15 year period:

Interest paid into savings account
(Total return at end of 2010)
Interest reinvested into fund
(Total return at end of 2010)
Initial amount invested
$10,000
Initial amount invested
$10,000
Interest credited at 15%pa
(15 yrs x $1,500pa)
$22,500
Interest credited due to compounding
$71,371
Total return
$32,500
Total return
$81,371

The effects of compounding are pretty staggering. By reinvesting the annual interest you've earned and using the marvel of compounding, you've come out ahead by $48,871. That's 8 times the initial investment, compared to 3 times if you'd had the interest paid into your savings account.

It gets even better the longer you have your money invested. This is what would happen if you'd invested for just another 5 years:

Interest paid into savings account
(Total return at end of 2015)
Interest reinvested into fund
(Total return at end of 2015)
Initial amount invested
$10,000
Initial amount invested
$10,000
Interest credited at 15%pa
(20 yrs x $1,500pa)
$30,000
Interest credited due to compounding
$153,665
Total return
$40,000
Total return
$163,665

Compounding now means your initial investment of $10,000 has been multiplied by 16 times, compared to 4 times with the savings account option.

And all of this happens without you adding anything to your initial $10,000 deposit. Imagine if you added a small, regular contribution to investment - the marvel of compounding would really boost your savings!

If you’d like to know more about the wonders of compounding, or even the wonders of investing, why not give us a call? Some great advice from a Big Sky Financial Solutions financial adviser can make a world of difference to your future.

Note: income tax payable on the earnings each year has not been taken into consideration in the above examples.

< Back