## måndag 31 oktober 2016

### The power of compounding

I tend to keep away from actual numbers on this blog, mostly as they are not my strong suite and that I want to the readers to do their own homework.
So lets see how that goes when we will cover the subject of compounding.

## Introduction

Compounding is the idea that when you receive interest on your investment and reinvest it you will start to receive interest on that interest as well. And next year, you will add another round of interest and so on. After some years, the snowball starts to build itself faster and faster.
This is the reason why you should reinvest your returns, be it interest rate or dividend payouts. The numbers go crazy after a few years.

## One time investment: Savings account vs. reinvesting

A very simplified scenario. Say you invest 100000. And each year, you will receive 6%. The following table shows the growth with and without reinvestment, i.e. compounding for the first 25 years. I.e. plain is your savings account with 0% interest.

 year savings account reinvested 1 100000 100000 2 100000 106000 3 100000 112360 4 100000 119101 5 100000 126247 6 100000 133822 7 100000 141851 8 100000 150363 9 100000 159384 10 100000 168947 11 100000 179084 12 100000 189829 13 100000 201219 14 100000 213292 15 100000 226090 16 100000 239655 17 100000 254035 18 100000 269277 19 100000 285433 20 100000 302559 21 100000 320713 22 100000 339956 23 100000 360353 24 100000 381974 25 100000 404893

The difference is a whooping 304893. Just by locking in your money and reinvesting each year the original investment has grown 4 times!
OK, the example is a little biased against the savings account. So lets look at a more realistic calculation.

## Continuous investment: savings vs reinvestment strategy

In a more realistic scenario you would continue to invest new money each year, say 30000 per year the numbers would be the following:
 year savings account + additional savings reinvested + additional investment 1 100000 100000 2 130000 136000 3 160000 174160 4 190000 214610 5 220000 257486 6 250000 302935 7 280000 351111 8 310000 402178 9 340000 456309 10 370000 513687 11 400000 574509 12 430000 638979 13 460000 707318 14 490000 779757 15 520000 856542 16 550000 937935 17 580000 1024211 18 610000 1115664 19 640000 1212603 20 670000 1315360 21 700000 1424281 22 730000 1539738 23 760000 1662122 24 790000 1791850 25 820000 1929361

The difference now would be 1109361. That's a lot of money.

## Living on the yearly returns

If you, like me, plan to live on the returns from your investment, given the above numbers the following would be paid out per year if you stop reinvesting.

 years savings account savings account  + additional investment reinvested reinvested  + additional investment 10 0 30000 for 10 years 10137 30821 15 0 30000 for 15 years 13565 51393 20 0 30000 for 20 years 18154 78922 25 0 30000 for 25 years 24294 115762 30 0 30000 for 30 years 32510 165062
Savings accounts: you would need to do withdrawals to get any money as most accounts have 0% interest rates.
After 10 years, the reinvesting plus additional investing will generate an extra investment unit of 30000 per year by itself. And after 25 years, it adds the initial investment each year!
And going from 25 to 30 years adds another ~50000 per year.

## Conclusion

I know my plan. Continuously invest and reinvest all dividends! Event if the 6% per year rate is just fake and in reality it would be different depending on a number of variables, taxes, costs, market fluctuations etc. But the effect of interest on interest on interest over and over again is just something that must be leveraged in any long term investment plan.

Hope this helped a little bit in showing how this effect works :)

Disclaimer. I am in no way an expert on capital management or investing. On this blog I only wish to share my findings, ideas and comments on current events and fields that interest me. I hope that my thoughts can entertain you. I expect that everyone reading take their time and do their own research before acting on anything read on this blog. Investing is not for everyone. E&OE.