One single investment strategy has probably made more people rich than all others combined. It’s a foundation of saving… yet it’s something that investors often ignore.
This magic is the power of compounding. It works by investing a sum of money that generates a steady return. But instead of taking that return and spending it, you reinvest it by buying more of the original investment. The next year both the original investment and the reinvested interest will earn interest, which you again reinvest.
With compounding, your original investment is growing in size due to repeated reinvestment, and every year you are getting a larger and larger sum of interest. It’s like a snowball rolling downhill, growing bigger in size as it picks up more snow on the way.
Let’s say an investor puts S$10,000 in a deposit paying 5% interest annually.
At the end of the first year, he is paid S$500 interest. But instead of taking this interest out of his account, the investor reinvests the S$500 on the same terms.
At the end of the second year, the investor will receive interest of S$525 (5% on S$10,000 + 5% on S$500). This is also reinvested, and the invested amount grows to S$11,025.
At the end of the third year, the investor will receive S$551.25 in dividends. His investible amount has now grown to S$11,576.25. Note the similarity to the snowball… the money that is working for the investor is growing larger every year.
The amount of interest the investor receives every year is increasing due to the magical effect of compounding.
An additional S$25 might not sound like much at first. But the beauty of compounding is what happens over a long period of time. That S$10,000 compounded over 10 years, at 5% per year, grows to over S$16,000. Over 30 years, it grows to S$43,219. And remember: If each year you had withdrawn and spent the S$500 interest, instead of reinvested it, at the end of 10 years, and 30 years, you would still just have S$10,000.
The power of compounding is far greater with larger returns. At a 10% annual return, you’d have S$25,937 after 10 years, and S$174,494 after 30 years. That’s a lot more than double what you’d earn at a 5% rate or return, thanks to compounding.
Apart from finding a reliable way to earn a good rate of return, time is the single most important factor that contributes to the power of compounding. Regular savings that start early in life and continue uninterrupted over the investor’s lifetime generate higher returns compared to those starting later in life, or those that stop saving earlier.
Taxes and transaction fees will take a bit away from your return. But the magic of compounding will more than make up for it.