With a little bit of interest and a lot of time, compound interest can help grow a portfolio significantly.
Compound interest is reinvesting earned interest back into the principal of an investment. The formulae for Compound Interest is A = P(1 + r/n)^nt. As you reinvest interest on top of interest, your investments can grow exponentially over time. Exponential growth is the result of letting interest compound over time.
The formulae for Compound Interest is A = P(1 + r/n)^nt;
A = Accrued Amount (principal + interest)
P = Principal Amount
I = Interest Amount
R = Annual Nominal Interest Rate in percent
r = Annual Nominal Interest Rate as a decimal
r = R/100
t = Time Involved in years, 0.5 years is calculated as 6 months, etc.
n = number of compounding periods per unit t; at the END of each period
This idea can be a little abstract, so let’s look at a hypothetical scenario to better understand the potential power of compound interest.
Suppose there are two investors who have a starting balance of R100,000.00 each. They both decide to buy the exact same investment on the same date. And they both plan to hold their investments for 30 years. But one investor plans to withdraw the interest at the end of each year, while the other plans to reinvest the interest and let it compound.
Let’s fast forward 30 years to see the difference in potential returns. In this example, let’s suppose that the investment earned 7% per year.
The investor withdrawing interest every year would’ve earned R7,000.00 per year. Over 30 years, the earnings would’ve totalled R210,000.00. But let’s see how much of a difference reinvesting the interest could’ve made.
The investor who reinvested the interest would’ve possibly earned R761,230. This is more than triple the returns of the other investor.
This example illustrates the power of compound interest. Now, let’s take it to another level and discuss the importance of time. Compounding over a long period of time can potentially lead to significant growth of an investment.
Let’s look at another hypothetical example to understand how important time is to compounding. Suppose two investors have portfolios worth R1,000,000.00 each.
The portfolios hold identical investments. Each year, both investors save and invest an additional R100,000.00. And let’s assume that with compounding, their portfolios grow 7% per year.
One investor needs the money to retire in 15 years. The other will need the money to retire in 30 years. Let’s see what a difference 15 years can make.
At the end of 15 years, the investor’s portfolio would have grown to R5,271,930.00. Now let’s see how much the other investor would have earned. The additional 15 years of compounding resulted in his portfolio growing to R17,058,330.00.
That’s over three times the return of the other investor. Now that you understand how time can impact growth, let’s discuss three ways how you can harness the power of compounding.
The first step, and perhaps one of the most important, is to start investing early. The earlier you start, the sooner you can start taking advantage of time.
The next step is reinvesting earnings. When it comes to investing, earnings are typically in the form of capital gains and dividends. Some brokers may allow you to automatically reinvest these earnings. Or you may choose to simply buy different investments.
The final step is to avoid one of the biggest obstacles many investors face taking excessive risks that can lead to large losses. After all, compounding only works if you’re earning on your investments.
Of course always earning a profit is easier said than done because investments sometimes make money and other times lose money. You can’t guarantee your investments will make money, but you can avoid taking excessive risks that may lead to large losses.
Measures such as allocating your portfolio across different asset classes and diversifying your portfolio within each asset class can help reduce some of the risk in a portfolio. However, asset allocation and diversification do not eliminate the risk of loss.
To potentially help avoid large losses, resist the temptations of taking excessive risks of not taking any risk and staying on the sidelines.
When it comes to compound interest, slow and steady can be a highly effective approach. This is not a get rich quick scheme. It works well in medium to long term.