The word 'compounding' is proof that the finance industry has really skimped on word smithing over the years. A Muggle word for a magical concept is a missed opportunity to get normal people excited about investing. And it's worth getting excited about compounding returns, here's why:
The secret sauce of successful investing
Compounding happens when you start with a number and increase it by a percentage, then you take the resulting number and increase it by a percentage. Rinse, repeat and watch the magic grow ever more powerful with time.
Let's try an example
Say you invest $1,000 today in an investment with a 10% return. 10% of $1,000 is $100, so here's how you might think your investment would look:
Year 0 (when you start): $1,000
Year 1: $1,000 + $100 = $1,100
Year 2: $1,000 + $100 + $100 = $1,200
Year 3: $1,000 + $100 + $100 + $100 = $1,300
Year 4: $1,000 + $100 + $100 + $100 + $100 = $1,400
Year 5: $1,000 + $100 + $100 + $100 + $100 + $100 = $1,500
Without doing anything, your money has grown by $500 over 5 years. Not bad!
Not bad, but not quite right. When you invest, your initial amount doesn't just grow by 10% every year, your money grows by 10% of the new amount every year. Let's run the math again:
Year 0 (when you start): $1,000
Year 1: $1,000 + ($1,000 x 10%) = $1,100
Year 2: $1,100 + ($1,100 x 10%) = $1,210
Year 3: $1,210 + ($1,210 x 10%) = $1,331
Year 4: $1,331 + ($1,331 x 10%) = $1,464.10
Year 5: $1,464.10 + ($1,464.10 x 10%) = $1,610.51
Your money actually grew by $610.51. Because every year, your returns are compounded, the money your money makes, makes you more money. We told you it was magic.
Here's another example:
If you invest $2040 on Day 0, after 65 years at 10% compounding annually it becomes over $1,000,000 - $1,000,356.28 to be exact! (Not accounting for inflation).
What's the difference between compounding growth on savings and investments?
You may have heard about compounding interest on your savings. It's the same concept - if you have $1,000 in a term deposit at a 1% interest rate, the total amount you have saved will grow by 1% a year.
When it comes to investing, the percentage your money grows isn't guaranteed. Historically, the share markets have increased in value by an average of about 10% a year... But they don't increase by 10% every year. Some years, your money may grow by 30%, other years, you may end up with less than you started with.
Because investing is a long-term game, compounding still works even if your shares don’t increase in value every year. How? Let’s use the same example as above with the last 5 years of share market returns:
Day 0 (1 Jan 2015): $1,000
2015 (1.4%): $1,000 + ($1,000 x 1.4%) = $1,014
2016 (12%): $1,014 + ($1,014 x 12%) = $1,135.68
2017 (21.8%): $1,135.68 + ($1,135.68 x 21.8%) = $1,383.26
2018 (-4.4%): $1,383.26 + ($1,383.26 x –4.4%) = $1,322.39
2019 (31.5%): $1,322.39 + ($1,322.39 x 31.5%) = $1,738.94
In 2018, the share markets finished the year with a –4.4% return. Ouch! But is it really that painful? Our hypothetical investment was still worth $1,322.39 at the end of the year – less than it was at the end of 2017, but still $322.39 more than we started with.
That’s because the loss was made on the total value of shares at the end of 2017, NOT on the amount we started with. One bad year just ate into some of the returns we’d already seen. Of course, this isn’t always the case, and sometimes you may find yourself in a position where your investment is worth less than what you paid for it. What then?
Well, when it comes to investing, we know three things:
One: Time is an investor's best friend
In the short term, it's hard to predict whether, or how much, the share markets will increase or decrease in value - share prices go up and down regularly. However, the long-term is (surprisingly) much easier to predict. Since 1928, the share markets have increased in value 75% of the time. To increase your chances of success, your best bet is to leave your investments as long as possible.
Want proof? Look at the share price chart for a large, well-established company, and they all start to look the same. The share price goes up and down over the short and even medium term, but in the long run (we’re talking decades), the graph line points up. If you look at the same graphs for the share markets as a whole, the story’s the same.
Two: Compounding growth gets more magical over time
Compounding works because the money your money has made, makes you more money. Look back at the examples above. In year one, your initial investment only made you a teeny amount. By doing nothing else, by year 5, that same initial investment earned you a lot more.
Three: It’s important to put share market losses into context
If you end any year with a ‘loss’ but your investment is still worth more than what you started with, have you really lost money? Even if your investment does dip below the amount you put in, what does it really mean? Look back at the example above. Selling at the end of 2018 because you made a loss would have meant forgoing the 31.5% increase the share market had in 2019! It’s all a loss ‘on paper’ until you sell your shares.
Notice a common theme? Time.
Compounding growth becomes more magical, the longer the timeframe. Every day your money is invested, is a day compounding could be working for you. We're talking real money, without you having to lift a finger. Think about how hard you work for that pay rise, why not put your money to work earning it for you?
Every percent makes a difference
Compounding may work in a similar way between saving and investing, but the devil is in the detail. Let's say you're tossing up where to put $1,000 that you're setting aside for the future. You may feel like it's better to leave your money in the bank and still benefit from compounding interest. We beg to differ:
Year 0 (when you start)
Your money has grown by
*Again, this isn't guaranteed, which is why we always say don't invest money you'll ever need in a hurry.
The compounding conclusion
It’s important to keep in mind that the average 10% return we’re talking about is for the share markets as a whole – individual company shares might have short (or even long) periods of higher growth, or they might end up worth nothing at all. So you need to do your research and think about things like diversification (spreading your money across a range of investments – check out Exchange-Traded Funds (ETFs), they can help with this!).
It’s also important to remember that, while bank accounts generally offer a fairly predictable small return (so you’ll see the benefits of compounding straight away), the effect of compounding growth in the share markets can take much longer. But predictability (and inflation) are costing you when it comes to compounding. As long as you have time, the share markets give your money a better chance to grow.