måndag 31 oktober 2016

The power of compounding

stack of coins in front of a clock

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.

yearssavings
account
savings account 
+ additional investment
reinvestedreinvested 
+ additional investment
10030000 for 10 years1013730821
15030000 for 15 years1356551393
20030000 for 20 years1815478922
25030000 for 25 years24294115762
30030000 for 30 years32510165062
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.

Inga kommentarer:

Skicka en kommentar