The power of compounding

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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.