It’s a single force with greater power to grow your wealth than all others combined. Despite that, it is also an often ignored investment strategy, though it is the foundation of saving and is guaranteed to make you richer. So, what is it?
One word: Compounding
How does it work? Simply put, you invest a sum of money that brings a steady return. Then, use that return to buy more of the original investment, reinvesting it instead of spending it. Repeat this pattern, reinvesting the growing return each year.
What sorcery is this? No, it’s not magic, but pure math… and time.
Compounding is also known as the snowball effect. As a snowball rolls downhill, it picks up more and more snow along its path, growing bigger and bigger in size. Similar in concept as compounding. Every year, a compounding investment picks up more and more interest or returns, growing in value.
How does compounding interest work?
For example, say an investor puts away S$10,000 and receives 5 percent interest per annum.
At the end of the first year, he earns S$500 in interest. He then adds this to the original S$10,000.
At the end of the second year, his interest has grown to S$525, since he is now earning interest on a S$10,500 investment.
In the third year, he earns S$551.25 in interest on his growing S$11,025 investment.
By the fourth year, he will be earning interest on S$11,576.25. The snowball effect means that his investment is growing exponentially year by year, as the chart below demonstrates.
The investor has made a choice. He could have withdrawn his yearly earnings of S$500 and spent it. After all, the extra S$25 that he could make in the second year by reinvesting the interest doesn’t seem worth it.
But when it comes to compounding, a long-term view is key. Over 10 years, the original S$10,000 with compounded 5 percent interest would snowball to over S$16,000. In 30 years, it would be S$43,219. If the investor had spent his interest instead, he would never have more than S$10,000, even if thirty years passed.
A greater interest rate would allow an investor to capitalise on the exponential force of compounding. A 10 percent interest rate would give him S$25,937 in 10 years and S$174,494 in 30 years. Double the return, quadruple the investment. That is the beauty of compounding.
Time is the best friend of compounding interest
Besides finding a good interest rate, the most important factor contributing to the power of compounding is time. Saving should start early in life and be allowed to continue growing uninterrupted. This will deliver higher earnings compared to starting late or stopping early.
It should be mentioned that there are some things that will take away from a return, such as taxes and transaction fees. But overall, the powerful force of compounding combined with an investors’ patience will bring its reward – ever increasing wealth.
This article first appeared on Truewealth Publishing.
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Kim Iskyan is the founder of Singapore-based Truewealth Publishing and the editor of Asian Investment Daily. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He’s been quoted in publications like the Economist, The New York Times, and more. He has also appeared on Fox Business News, Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications.
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