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Compounding investments can allow investors to grow their savings or investment portfolio over time. The more time that investors allow compounding to work, the greater the impact could be. Learn how to use compounding to your advantage and ways to potentially maximise returns.
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Compounding is the process of making interest or gains from accumulated interest or gains. Albert Einstein called compounding the eighth wonder of the world. Warren Buffett, one of the world’s most successful investors, warns against timing the market but encourages time in the market.
The power of compounding is subtle at first but can build over time. Take, for example, a UK compound interest investment of £100 that earns 10% interest on investment. After one year, that £100 is £110, and now that amount earns 10% interest. As a result, the next year you will have £121. That extra pound is the effect of compound interest. Over many years, compounding can become substantial.
Interest and dividends compound returns because the funds received can be reinvested, and those funds received earn interest or dividends too. This helps to grow capital more quickly, compared to interest and dividends being removed from the account.
Price growth of an investment also tends to compound upon itself. For example, if a stock gains in price by 1% one day and then another 1% the next day, the second day’s 1% gain will be on top of the initial gain.
The more quickly gains/interest/dividends are received, the more quickly the money can be compounded upon. Getting paid interest each month is better for some than being paid once per year. Those initial interest payments can be reinvested and may benefit from the interest payments for the rest of the year.
Simply being invested in stocks also results in compounding (even without dividends), albeit indirectly, assuming the company is growing. Companies can compound their growth by reinvesting their profits to produce more revenue and profits. If the company does this well, it will likely be reflected by a rising share price over time.
Let’s look at an example of a dividend stock that pays 4% per year, where the dividends are reinvested. We’ll look at one example where the dividend is only paid once per year and another example where it is paid out monthly (1% every three months), using a £1,000 investment.
Source: https://www.getsmarteraboutmoney.ca/calculators/compound-interest-calculator/
| Amount | Year |
|---|---|
| £1,000.00 | 0 |
| £1,040.00 | 1 |
| £1,081.16 | 2 |
| £1,216.65 | 5 |
| £1,480.24 | 10 |
| £1,800.94 | 15 |
| £2,191.12 | 20 |
For comparison, if there is no compounding, the person makes £40 per year. At year 20, they have £1,800 instead of £2,191.12
Next, we’ll look at the compound return for a £1,000 investment in a 4% dividend stock that pays out quarterly (1% per quarter).
| Amount | Year |
|---|---|
| £1,000.00 | 0 |
| £1,040.60 | 1 |
| £1,082.86 | 2 |
| £1,220.19 | 5 |
| £1,488.86 | 10 |
| £1,816.70 | 15 |
| £2,216.72 | 20 |
The quarterly option provides more payments, which in turn provides more interest compared to the annual option.
Is now a good time to invest? Compounding has the most effect over long periods of time. Some financial advisers recommend that people start investing and saving as young as possible, even if the amount invested isn’t a lot. Over time, the capital can grow substantially.
Here is an example of how much someone can grow their capital if they start investing at 20-years-old and compound their money until they are 65 years old, according to calculations from Get Smarter About Money. Assume they earn 6% per year and contribute £500/month over that time. Interest is compounded yearly.
| Amount invested | Year | Amount at end of year with monthly contributions |
|---|---|---|
| £6,000 | 1 (20-years-old) | £6,163.26 |
| £10,000 | 2 | £12,696.32 |
| £25,000 | 5 | £34,742.89 |
| £50,000 | 10 | £81,236.72 |
| £75,000 | 15 | £143,455.95 |
| £100,000 | 20 | £226,719.32 |
| £150,000 | 30 | £487,256.49 |
| £225,000 | 45 (65-years-old) | £1,311,194.48 |
Next, let’s look at an example where someone starts investing at 40-years-old and contributes £1,000 per month. They make 6% per year, and this continues for 25 years until they are 65 years old.
| Amount invested | Year | Amount at the end of year with monthly contributions |
|---|---|---|
| £12,000 | 1 (40-years-old) | £12,326.53 |
| £24,000 | 2 | £25,392.65 |
| £60,000 | 5 | £69,485.79 |
| £120,000 | 10 | £162,473.44 |
| £75,000 | 15 | £286,911.90 |
| £180,000 | 20 | £453,438.63 |
| £300,000 | 25 (65-years-old) | £676,288.96 |
Even though the person who started later contributed much more capital to their retirement, they end up with less money because compounding doesn’t have as much time to work. The person who started earlier contributed £75,000 less but ended up with a nest egg nearly double the size.
Stock market index exchange-traded funds (ETFs). Stocks market indices tend to rise over time if companies grow. Companies that can’t compete and subsequently fail are removed from the index. Companies that grow will likely create a compounding effect; the index rises, and the investor rides along with it if they own shares of the index ETF. Some companies within the index also pay dividends, and those dividends can be reinvested in the index fund (or another one) to enhance returns.
Individual stocks. Individual stocks can have a compounding effect if the company is reinvesting their profits to create more profits. The investor is taken along as the company grows. Investors can also learn how to invest in stocks for profit and then reinvest those profits, compounding the returns themselves, or allow those gains to naturally compound as the price of the stock moves higher over a long period of time.
Dividend stocks. Dividend stocks pay out dividends, typically monthly, quarterly, biannually or sometimes yearly. These funds can then be reinvested in the same stock or another stock to compound returns, as those reinvested funds will also make dividends/returns going forward.
Bonds. Bonds are a compounding interest investment, paying out interest at regular intervals. The interest can be reinvested in other bonds or stocks, compounding returns. If you own a bond ETF, the ETF may pay out interest. You can elect to have those funds reinvested, or you can take the funds and reinvest them yourself.
Accumulating ETFs. Accumulating ETFs don’t distribute any funds that are received from the bonds or dividend stocks it holds. Instead, it reinvests those funds automatically. This differs from a distributing fund that pays out dividends.
Savings accounts compound their interest over time, but not at the same rate as stock market returns, dividend stocks, or bonds.
Savings accounts typically pay less than a 1% annual interest rate, according to Bankrate, while dividends can pay 3% or more. Meanwhile, the stock market has averaged 8% to 10% returns using passive investing strategies, and bonds have averaged near 5% simple interest over the long run, according to data from Business Insider and CNN.
| Contribute £500 per month | Savings account at 1% | Bonds at 5% | Stock index fund at 8% |
|---|---|---|---|
| Year 1 | £6,027.45 | £6,136.29 | £6,216.94 |
| Year 2 | £12,115.18 | £12,579.39 | £12,931.24 |
| Year 5 | £30,746.06 | £33,906.87 | £36,472.33 |
Even over a few years, there is a significant difference between a savings account and the average stock index fund or bond return. That said, there is little risk of loss in a savings account, while stocks and bonds could lose money in some years.
Savings accounts are a type of short-term investment, so explore the differences between saving vs investing in more depth.
Compound interest investment plans reinvest dividends and interest, so these reinvested payouts make interest and dividends as well. The plan can also include growth stocks. However, these typically don’t pay dividends. The companies themselves are compounding their returns, which may push the stock price up. These stocks can be sold when they are no longer growing and the gains can be reinvested into other growing assets. However, bonds, dividends, and growth stock ETFs can be viable options for some as opposed to picking individual securities.
People looking for the highest return may focus more on investing strategies centred around growth stocks, as these tend to produce the highest returns. Dividends and bonds can also be included. The portfolio may look something like this: 20% in bonds, 50% in dividends or stock index ETFs, 20% in growth stock ETFs, and 10% in cash.
A more conservative investor may focus on more stable dividend stocks and index funds, as well as a higher concentration in bonds. That portfolio may look like this: 60% in bonds, 30% in dividend and stock index ETFs, and 10% in cash. You can adjust these percentages to suit your own personal preference and risk tolerance.
Accumulating ETFs don’t distribute dividends and instead reinvest them automatically.
Some stocks and ETFs that pay dividends (and distribute them) offer a dividend reinvestment plan (DRIP) where the investor signs up to have their dividends reinvested. Check with the company or ETF to see if this is offered on your investments.
In all cases, whatever funds you receive via interest or dividends, you can always reinvest it yourself to compound your returns.
FAQs
It has the potential to, although it will depend on factors such as the amount contributed to the compounding investment, how long that investment is held and what the interest rate is. The higher the interest, the more often it compounds, the longer the time horizon and the more that’s contributed may all help boost returns.
Simple interest is based only on the initial amount of the investment. Compound interest pays interest on the initial investment amount, as well as on interest already received.
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