Compound returns are sometimes referred to as the eighth wonder of the world. They are also an investor’s best friend. As Albert Einstein once said, “The most powerful force in universe is COMPOUNDING!”
The basic concept is simple. In the first year of investing, you generate returns on your initial investment. In the second year, you invest the capital plus the returns, and you generate further returns on the total. And so it goes on, and your money snowballs into a pot that you can eventually retire on.
Of course, investing is always subject to the ups and downs of the stock market, so returns aren’t guaranteed every year. However, by investing over a long timeframe, you give your investment time to make up for any losses.
Underestimating the power of compounding
There have been many studies into compound returns and why we fail to mentally account for them properly. One such study was conducted by Craig McKenzie and Michael Liersch at the University of California.
They asked groups of undergraduate students in the USA to consider how much their savings would grow if they deposited $400 per month into an investment which grew at 10% per year.
One group were given calculators and asked for a calculated answer, the other group were given no aid at all and asked for a best guess.
The results? 90% of respondents got it wrong. Both groups grossly underestimated the final value of the portfolio, as they failed to take compounding into account. The average guess for the portfolio size after 40 years was $500,000. The correct figure is around $2.5 million.
Little things mean a lot
Seeing the full benefit of compound returns is all about time and patience. That means that you don’t have to stash half your income away immediately. If you commit to saving as much as you can every month and make regular contributions to your investments or savings account, small amounts can soon add up. Remember, compounding growth assets Exponentially , NOT Linearly.
Correspondingly, what seems like a small disparity in rate of return can soon start making a big difference. Interest rates are persistently low at the moment, and it pays to shop around for the best rate.
Here is a worked example:
Suppose you invested £10,000 in a savings account, and after 5 years, the account balance grew to £15,000.
Beginning Value (BV) = £10,000
Ending Value (EV) = £15,000
Number of Periods (N) = 5 years
Using the compound return formula:
Compound Return = (EV / BV)^(1 / N) – 1
= (£15,000 / £10,000)^(1 / 5) – 1
≈ 1.5^(0.2) – 1
≈ 1.095 – 1
≈ 0.095 * 100
Therefore, the compound return for this investment over five years in British pounds is approximately 9.5%.
Many ISA providers have generous introductory offers, and then reduce your interest rate after the account has been open for one year. Be vigilant, keep on top of what rate you’re getting and switch providers if you can get a better deal elsewhere.
Here is a parting quote from Ben Franklin,”Money makes money and the money that makes money, MAKES MONEY.”