I started researching the topic of investing a couple of years back. I knew that I need to find a way to make money work for me rather than me working for money. This is where the term of compounding and I crossed our paths.
Firstly, seeing the past performance of the stock markets was exciting. Secondly, the fact that I can turn it into passive income source was the amazing. Finally, making money while I am out with friends and family was the cherry on the top.
It isn’t a get rich quick scheme in my view and takes time to build your portfolio. Once you get to a decent size portfolio – the money will start coming in. Making 10% return on £1,000 portfolio doesn’t sound impressive. However, the same 10% on a portfolio of £100,000 – now we are talking, right?!
The term of compounding will become your best friend if you are like me and decide to start investing. This action will definitely change your life for good and will be something you will be grateful for.
what is compounding
In very simple terms – compounding is your interest earning you more interest. A very simple example of this – you lend me £100 and in a year I give you £110 back. You made yourself extra £10 or 10%.
In order for you to experience the effect of compounding – you then have to find someone else who needs money. In the ideal world you will look for the same or better interest and lend the whole amount you have – the £110. If you were to do that at 10% again, at the end of year 2 you would have £121.
You would have made the same £10 of interest on the initial £100 you had. The beauty here is – the £10 that you made in the first year would make you an extra £1 of returns in the second year.
As you keep doing this – the snowball effect starts to take place. The returns that you make for yourself are starting to work for you. After a certain period of time it will be the returns that you made over time that will be earning you the most rather than your initial investment.
This concept is illustrated really well in the image below. If you were to only invest your £100 every year and spend the interest that you are making then the returns would remain at £10 and you would be on the simple interest line. However, the longer you reinvest the money you make – the higher up the compound interest curve you get.
The compounding is the real beauty of this game that will change your life for ever.
how to benefit from compounding
Firstly, in order to benefit from this phenomena you obviously need to be invested. Secondly, all the profits and dividends you get out of your investments need to be reinvested back. You can use some of the profits for other needs but this will reduce the compounding benefit you will get.
Some companies that offer their index fund trackers offer to reinvest dividends for you. Vanguard is one of the cheapest investment companies to use in my personal experience. Their fees are extremely low and many of their products they simply track index funds. This makes them also very tax efficient compared to actively managed funds.
On some of Vanguards products you can find that all the dividends are accumulated rather than distributed. What this means is that Vanguard collects your dividends for you and reinvests these back into the index fund you are holding. This grows the value of your investment quicker over time compared to the value of the index itself.
This way, your dividends get to work for you straight away. One of the examples of this type of fund can be found here.
You can also do the same with the dividends you receive on your own. The biggest watch out here is as follows – keep an eye on the fees you have to pay. Many platforms charge a flat fee per transaction. Make sure the dividends you reinvest are worth it when compared to the size of of fees you are expected to pay.
the rule of 72
One other thing definitely worth knowing for anyone trying to build their investing strategy around compounding – the rule of 72.
This is a very simple and basic formula that lets any investor figure out how long it will take for their investment to double.
A simple example is – let’s assume you invest in an index fund and get 9% growth every single year without a fail. What the rule states – 72/9=8. This means that if you were to invest £1,000 into the above index fund in 8 years time your investment would be worth £2,000. This assumes you get 9% return every year.
The value would double once again in 8 more years time. This would make your investment worth £4,000. And so on….
You can see how the power of compounding is really starting to work for you here.
summary
Investing is something I would strongly encourage everyone to do no matter how much or little you can afford to invest. If you are not sure on where to start – these 2 articles are a great start (investing your first £1,000 & dividend stocks at a cost of a cappuccino).
From the above you can really start seeing how small investments can add up through the power of compounding. You have now also learned an easy way to calculate how long it will take for your investment to double in its value.
Use all of the above and start building your own investment portfolio. You will certainly be thanking yourself for the decision you made and will start seeing the results of this in your bank account as well.