One of the most important investment concepts people need to understand is the concept of compounding.
In a nutshell, compounding means that your investment returns – dividend income or interest, for example -, also produce investment returns if you reinvested them.
Assume, for instance, you invested $10,000 into a stock with a 5 percent dividend yield, meaning you make $500 in dividends in year 1 (no assumption of taxes for simplicity reasons). If you reinvested your $500 in dividend income once again into the same stock or a bond yielding 5 percent, this additional $500 from your first year will now also earn you money. How much? $25 to be exact ($500 x 0.05).
Earning returns on your previous investment returns is called compounding, and the long-term wealth effect of compounded returns is significant.
Unfortunately, people greatly underestimate the power of compounding long-term. Just look at the example we just went through. If you invested $10,000 into a stock, $25 additional yearly income in the following year doesn’t appear to move the needle, right? But nothing could be further from the truth!
Compounding Returns Has A Huge Wealth Impact Long-Term
Compounding (a.k.a. reinvestment of investment returns) contributes a significant chunk of wealth over the long haul, and smart investors need to harness this wealth building power at all costs.
Here’s a good chart that illustrates the power of compounding long-term.
Consider three young investors (Susan, Bill and Chris) that save money during different periods of their lives.
Susan, for example, invests $50,000 in total between the ages of 25 and 35 and she has more money at the age of 65 than Bill who invested a whopping $150,000 between the ages of 35 and 65. Get this: Susan invested $100,000 less than Bill, yet comes out ahead of him!
The difference in wealth at the end of the investment horizon is explained by Susan saving and investing money earlier than Bill, which in turn means her money can compound over a longer period of time.
Chris, on the other hand, is the real champ here: Not only does he save money early (starting at 25 years of age) but he also shows persistence, stashing away $5,000 annually until the age of 65. Chris invests only $50,000 more than Bill does over his working life, but ends up having a nest egg worth twice as much as Bill’s.
In order to be able to take full advantage of compounding money and achieving a comfortable level of wealth long-term, you have to do two things: 1. Start saving and investing money today; and 2. Stick with your investment plan for the long haul, i.e. make contributions to your investment/retirement account regularly, and don’t be swayed by the mood of the capital markets.
Starting to save money early in life and sticking with your savings goals throughout the inevitable ups and downs in life and the stock market is crucial to gaining financial independence!
The lesson here is obvious: Be Chris, not Bill.
Start saving money TODAY.
Learning From Warren Buffett
Saving money, of course, is only one skill you need to possess in order to accumulate a decent-sized nest egg to mooch off of in retirement. As long as you understand the power of compounding, however, you have got a major advantage over others that don’t understand the power of this crucial investing concept.
Warren Buffett, the world’s most successful investor, got rich largely because of the power of compounding.
There is a lot to learn from Warren Buffett, from how to evaluate investments, how to think about price and value, and how to deal with market volatility. I have read a lot of material related to Warren Buffett, including his annual shareholder letters, and they are an invaluable resource. Check out my resource page for books I recommend.
Compounding, as we just learned, requires you to reinvest investment income consistently.
Don’t give in to the temptation and spend it on consumer goods or nonsense that you don’t need. Prioritizing your savings goals, also called “paying yourself first”, requires you to reinvest investment earnings right away. Compounding effects only kick in long-term, say after 20 years or so. Investing is a marathon, and not a sprint!
Be a saver, not a spender!