Compounding refers to the effect of reinvesting interest or income from a share or fund to increase earnings over time. Over time the growth and interest compounds and the theory is will generate stronger capital growth.
In many ways, Compounding is essentially a ‘snowball effect’. You investment may start off quite small, but over a long period of time it grows on average year on year, and the interest or income you receive increases. When you invest for a long time and reinvest your income, the ‘ snowball effect’ or compounding can be a great way to easily boost capital growth.
Things Grow with Time
How soon you choose to invest is a key aspect of maximum compounding. Let’s say you and a friend are investing to support the purchase of a new holiday home each at the age of 60.
You start earlier than your friend, investing at 35 and stop at 45 investing £5,000 per year or £50,000 in total. Despite not adding to your investment after the age of 45, you remain invested until you cash out at 60.
Your friend starts investing later at 45, but carries on investing until 60. They have invested £75,000 in total with a view to exit their investments at 60 to purchase the holiday home. Like you they invested £5,000 per year but over a period of 15 years rather than 10.
If you look at the numbers and ask who has more money from their investments, the answer would be your friend because they invested £75,000. But this would be unlikely (providing your investment was growing).
We won’t go into the calculations or assumptions. But what’s key here is to understand that you started investing at 35, your investment had 10 years of year-on-year growth (hopefully) before your friend started investing. So your early investment had a maximum window of 25 years to compound or snowball. Your friend’s investment while bigger at the start, only had 15 years to snowball!
The Interest or Dividends from your Investment – Give, don’t Take
Now when you combine the time invested with potential income, you supercharge compounding and your capital gains. Perhaps the mechanics of this point is best illustrated when you buy a fund. You will be asked if you want to purchase accumulation units or income units. Accumulation units refers to reinvesting the dividends or interest from the holdings of the fund to buy more units of the fund. Income units means just taking the cash from the dividends or interests and pocketing it.
But if you are on the hunt for Capital Growth, taking income units in this situation could limit the maximum return of your investment.
Why? It links into the first point of time invested. Now if your investment is growing in value with more time, adding more money to that growing investment year-on-year is only going to increase the value of your holding and also the amount of dividend or interest you receive and subsequently reinvest.
If you’re looking at individual shares, then finding sustainable and good dividend payers are key to benefiting from this. Ratios such as the dividend yield and dividend cover are useful. If you are buying funds and in particular income funds, look at the holdings and try to assess how sustainable the dividend has been and is likely to be based on the company’s prospects.
As Warren Buffett Says…
The benefits of Compounding are perhaps best summarised by Warren Buffett, legendary American Investor with a Net Worth of c. $70bn (although that can change from time-to-time, but it’s still a lot):