How can investors receive compounding returns? This was a question posed to me Sunday night during one of our weekly webinars from a new client. We have been writing a fair amount of posts lately directly from client questions as we believe they add a ton of value. If one of our clients feels like this is something they do not know we are confident that other clients and readers of this blog would love to know the answers as well. Compounding interest is something everyone should become familiar with as it can add many multiples of profit to your portfolio over time. Remember, we at Stony Brook Securities do not believe wealth can be created overnight, rather we believe anyone can create wealth in the financial markets by making small smart decisions over and over again. We will spend the rest of this post answering the question to how can investors receive compounding returns?
How Can Investors Receive Compounding Returns? What the “Pro’s” Will Say.
This video is the standard type of video from Wall Street. They give some crazy definition that is incredibly overcomplicated to start with by saying:
Compound interest is the interest an investor earns on his original investment plus all the interest on the interest that has accumulated over time
That was a long one. But the short answer to our client question of “how can investors receive compounding returns?” can be summed up nicely here by saying:
The compounded returns on our reinvestments
Nice and easy. Simple for everyone to understand. Any interest, dividends, or gains can be reinvested in the original investment to create compounded gains. Rather than taking those interest, dividends, or gains in the form of cash payments, we can compound those gains by reinvesting them to “let the money our money made grow” if you will…
Let’s look at an example.
How Can Investors Receive Compounding Returns? By Using Simple Math!
Here is the formula for compounding interest:
Here we have a few variables that we should clear up.
P: initial amount (principal)
r: annual interest rate
n: number of times the interest is compounded per year
t: number of years the money is getting compounded for
What if we put our money in an online savings account? Right now, at Goldman Sachs, anyone can get 1.05% on their money in an online savings account. If we start with $25,000, what can we expect to gain after 1 year?
We know that 1.05% of $25,000 is $262.5…so why do we actually end up with $25,263.77? Since we are compounding this every month, we are earning additional interest (ever so small in 2017) on that tiny interest that ends up amounting to $1.27 over one year. These are real numbers people. But what about over 50 years?
If we did not have compounding interest, we would total $38,125 here but with the power of compounding interest we earn more than 10% more and end up with $42,251.77.
So how can investors receive compounding returns? You can put your money in an online savings account that gets compounded ever so small every month or you can invest that money and get a little more than 1.05%. Let’s use an IRA as an example here with a 6% return rate each year.
Here is what it would look like if we only put in the principal amount of $5,500 and never added any more contributions:
After 30 years we would end up with $31,589.20. But what if we contributed $5,500 each year and reinvested our gains (6%)?
Not bad playa! We began with $5,500. We earned 6% per year (because we are such great consistent investors). Every year for 30 years, we contributed the max $5,500. In total over those 30 years, we would have contributed $170,500. The interest we would have earned over that same 30-year span would have been $321.998.44.
What if we were a nasty investor and were able to return 12% and reinvest those profits in order to get compounded gains? How can investors receive compounding returns? Since at a 6% rate we ended up with $321,998.44 do we think if we were able to double our returns (12%) we would end up with a double? Watch 🙂
Nope! We made almost five times as much money. That is the power of compounded returns. Like the previous example, over 30 years we contributed the same amount of $170,500. This time, the interest earned was $1,480,888.98. You are a millionaire, my friend. When we break it down like that it doesn’t seem like the most ridiculous goal ever, does it? And specifically with an IRA the gains made throughout the 30 years are not taxed as they grow. So this is a perfect example of compounding interest when we contribute yearly.
How Can Investors Receive Compounding Returns? Bonds?
Well, what about bonds? I thought they did not have compounded interest as they are similar to an online saving account with a fixed rate of interest but without the ability to compound that interest. You would be correct.
But let’s have some fun with it! Let’s say we put $100,000 into a 30 Year US Treasury Bond right now and we receive 3% on out money each year. We will do our best here to see if we can compound fixed income.
By buying this bond we will earn $1,500 twice a year in interest payments. But what if we took those interest payments and received additional interest on those? Isn’t that what compounded interest is? Interest on interest?
We take our $1,500 interest payment and buy a 1 Year US Treasury Bond with that and receive let’s say 1%. One year later we would receive the $1,500 plus an additional $15 for a total of $1,515. We do this again and again and again for 30 years twice a year. If we just bought the bond normally, we would receive $90,000 in interest over 30 years plus the $100,000 principal. With our cool little compounded interest on fixed income, we would receive over $115,000 in interest over 30 years plus the $100,000 principal. That is the power of compounded interest!
Simply reinvesting interest, dividends, or gains is the standard way of creating wealth over time with the help of compounded interest. But sometimes it takes a little imagination to do it with fixed income…but it can be done! Compound it and make it grow and work for you any way humanly possible.