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Compound investing SM Tile

How compound investing works

April 27, 2020

It’s one of the most important financial concepts to understand and leverage to reach your financial goals.

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You’ve likely heard of this personal finance principle before, but what does it really mean? And how can simple math turn your investments into a much larger nest egg? In short: compound returns plus time. Here’s what you need to know.

What is compounding?

Think about the money you have in a savings account. Every month, those dollars earn interest. While the first interest payment is calculated based on what’s in your account the first time you deposit those dollars, every subsequent interest payment is calculated based on the principle and the interest the bank has already paid out. If you have $100 in the account and earn 2% on that money annually, then you’ll have $102 by the end of the year. The next year, interest is calculated on $102 instead of $100, assuming you’ve made no further deposits.

Compounding, in other words, is when you earn interest on your interest, and that can snowball into bigger gains over time. This is especially true for investment earnings, which can potentially deliver larger rates of return than savings accounts. The greater those returns, the faster your nest egg will grow.

Time is power

In his book Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, Andrew Hallam calls compounding returns the world’s most powerful financial concept. To illustrate the snowball effect of compounding over time, he uses the following example, which you can replicate using a compound interest calculator.

Say you invest $100 with a 10% annual rate of return. (Rates of return are lower these days, but we’ll go with this for simplicity.) Thanks to compounding, you’d end up with:

  • $259.37 after 10 years
  • $672.74 after 20 years
  • $1,744.94 after 30 years
  • $4,525.92 after 40 years
  • $11,739.08 after 50 years
  • $30,448.16 after 60 years
  • $78,974.69 after 70 years
  • $204,840.02 after 80 years
  • $531,302.23 after 90 years
  • $1,378,061.23 after 100 years

While most of us don’t have 100 years to let our money grow, the example shows how even a tiny one-time investment of $100 can grow exponentially by compounding over time.

Another way to figure out how compounding could impact your investments is to use the rule of 72, which tells you how many years it takes to double your investment when returns are compounded annually. Divide 72 by your annual rate of return to get the answer in years. For example, using a 6% average annual investment return, it would take 12 years to double your investment.

Compound investing with monthly contributions

Let’s look at a more realistic example. Say you decide to invest an initial amount of $10,000 in a conservative investment portfolio that pays average annual returns of 5%. You also set up automatic contributions of $500 a month, and your portfolio is held in a Tax-Free Savings Account or a Registered Retirement Savings Plan so that you aren’t paying taxes on any investment returns (note: you would, however, pay tax on any RRSP withdrawals). Here’s what your portfolio would be worth after 10, 20, 30, and 40 years:

Day 1

After 10 years

After 20 years

After 30 years

After 40 years

Deposits

$10,000

$70,000

$130,000

$190,000

$250,000

Investment earnings

--

$23,470

$99,435

$260,907

$561,662

Balance

$10,000

$93,470

$229,435

$450,907

$811,662

With a relatively small initial investment ($10,000), additional investment contributions of $6,000 per year, and a modest (5%) average annual rate of return, you would more than triple your investments to a total of nearly $812,000 in 40 years. Such is the power of compounding.

As well, when it comes to savings accounts, the interest that’s paid out can be calculated daily, quarterly, or annually. The more frequent the payment period, the more you’ll have to compound.

To take advantage of compounding, start investing in a well-diversified portfolio as early as you can and contribute to it regularly. With dedication, time, and compounding, you can reach your goals sooner than you might think.

 


Disclosure: Mawer Investment Management Ltd. provides this publication for informational purposes only and it is not and should not be construed as professional advice. The information contained in this publication is based on material believed to be reliable at the time of publication and Mawer Investment Management Ltd. cannot guarantee that the information is accurate or complete. Individuals should contact their account representative for professional advice regarding their personal circumstances and/or financial position. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estates law. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances.

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