Compounding/Compound Interest Has Two Faces
Compounding/Compound Interest Has Two Faces
Compound interest arises when you start earning interest on your original investment as well as on interest that you earned in previous years or months.
Here is how it works:
Suppose Jack invests $1000 in a bank account paying 10% interest for three years. Jack does not make any additional deposits during this period. His investment will grow as follows:
Scenario 1: Jack does not withdraw the interest
Year, Start value, Interest, End value
1, $1000, $100, $1100
2, $1100, $110, $1210
3, $1210, $121, $1331
Scenario 2: Jack withdraws the interest every year
Year, Start value, Interest withdrawal, End value
1, $1000, $100, $1000
2, $1000, $100, $1000
3, $1000, $100, $1000
In year 1, the investment earns $100 interest. By reinvesting the interest (Scenario 1), Jack will have $1100 in his bank account.
At the end of year 2, his investment will be worth $1210. Rather than earning $100 like in year 1, the investment earns an additional $10 because the $100 interest gained in year 1 will also grow by 10%.
In year three, the account gains $11 interest on the $110 interest earned in year 2 leaving a balance of $1331 at the end of year 3.
By withdrawing the interest every year (Scenario 2), Jack will not benefit from compounding or interest on interest earnings.
Compounding only works if you reinvest your earnings.
This brings us to another important point:
Compound interest has a greater effect over the long term.
Let's assume that Jack (who is 50 years old) invested his money at age 30. His twin brother (Jackie) only started investing at age 35. Like Jack, he also invested $1000 at 10% interest.
What do their respective bank balances show at age 50?
Jack's balance: $6727
Jackie's balance: $4177
Difference: $2550
Both brothers invested the same amount at identical interest rates. But by leaving his account to grow for a longer period of time, Jack managed to gain an extra $2550.
The longer you leave your investment the greater the compound interest effect, which is why the experts encourage you to start saving/investing as early as possible.
Beware the dark side of compounding.
Compounding is what all investors are after, but negative compounding is a major cause for concern.
The power of compounding is harnessed when your investments are exposed to positive returns each and every year. A $1000 in a mutual fund realising 15% every year will grow to $2011, $4046 and $16367 after 5, 10 and 20 years respectively.
The only problem is that negative growth periods can wreck your gains. And if you have consecutive periods of negative growth, consider your financial plans screwed. A $1000 investment that loses 50% of its value will have to grow 100% just too breakeven.
Two key lessons:
Successful investors actively manage their investments to offset the effects of negative compounding.
You will have to endure negative compounding with a buy and hold strategy. Seek out businesses that pay you passive income and capitalise on customer needs, rather than expose your returns to the tides of economic cycles.
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