The power of compouding explained
Compounding, or compound interest. You have heard of it, but what is it and what does it mean? Basicly it’s earning interest on your interest, it’s the basis of ‘making your money earn money for you’.
Compound interest is simply explained with this example:
You have a bank account, it yields you 1% interest for the entire year, you deposit €100. At the end of year one, you have €101. Now this extra €1 will earn you another €0,01 the follow year. So at the end of year two, instead of making €1,00, you earn €1,01.
Means nothing right? It’s so insignificant that it hardly matters? Wrong!
This time let’s do the same example with €100.000.
Year one yields you €1.000, year two yields you €1.010, year three yields you €1.020,10.
Still seems a bit insignificant? I can understand. Compounding gets better and better with one secret ingredient, which is time. The longer you’ll let your money get compounded the steeper the raises get. Let’s change it up even more, instead of the low 1% yield, let’s grab 3,5% (it’s up to you if this will be for stocks or a ‘normalized’ bank account rate). And I will show you a graph of 40 years of running time.
You can clearly see the steps are getting bigger and bigger, the true potential of compounding is at the end. The longer you’ll let your money compound the more effect it has. You end up with €395.925,27, you nearly quadrupled your money, on just 3,5% yield. This gain comes down to earning €7.398,13 every year, while the first year your intrest is only €3.500. Magical, isn’t it? Albert Einstein once said “Compound interest is the eight wonder of the world. He who understands it, earns it… He who doesn’t, pays it.”
In case I have not won you over with this one simple example, let’s do another one. We will make it a bit more specific to investing this time. Combining dividend growth with compounding is where my heart really starts beating faster, and maybe in a minute it will make yours beat faster too!
Let’s assume you have a diversified portfolio yielding 3,5%, some good old blue chips grow their dividend slowly, some newer companies keep raising their dividend higher and higher like their life depends on it, averaging dividend increases of let’s say 7% per year. Now you get most of your dividends paid every quarter, which allows for faster compounding than yearly distribution. And the icing on the cake is reinvesting your dividends, through a Dividend Reinvestment Plan, or manually, it doesn’t really matter as long as your little friends go out there to make more friends for you.
This graph shows that in 40 years, with just reinvesting your dividends to let the compounding happen, you almost earn your initial investment amount, yearly. Now imagine if you’d put fresh capital to work alongside this.
It’s not a ‘get rich quick scheme’, as you can see it takes a considerable amount of time, but this way anyone can become a millionare with just dedication, a few stock picks and most importantly; time.
I sincerely hope people new to investing and compounding are not put off by the example number used (€100.000). The message I’m trying to get across is that no matter what your financial situation is, you should start paying yourself first, setting aside as much money as possible and just start! The best time to start was yesterday, the second best time is right now!