Many people getting into investing are keen to understand something. How can investors receive compounding returns?
If that question is at the forefront of an investor’s mind, they are certainly on the right track. There is no doubt that compounding interest and compounding returns drive the American economy.
But perhaps the investor is new to this confusing and, at times, complicated financial landscape. They’re looking for definitions and everyday examples of what compound returns and compound interest.
So how can investors receive compounding returns again? This guide is for investors seeking to educate themselves on all things compounding: compounding returns, compound interest, the risks, and the rewards. Read on, and find out!
Who knew that compounding is so exciting? It started as a genius mathematical concept, and it’s widely thought that Albert Einstein referred to the process of compounding as the “8th Wonder of the World.”
That makes a great story! But in fact, there’s no real evidence that Einstein said anything of the sort about compounding. It’s certainly doubtful that he gave his two cents’ worth about how investors can receive compounding returns.
But one famous American—Benjamin Franklin—did provide the best, simplest definition of compounding from a financial perspective. As Franklin put it, “money makes money. And the money that money makes, makes money.” Might sound like a tongue twister, but Franklin had it right.
Calling All Compounding Returns
A compound return is an incredibly accurate marker on investment performance in financial terms, especially when the investment is allowed to grow to maximum value over time. Anyone who understands this basic premise will know how investors can receive full compounding returns.
Here are two good-to-knows on compounding returns:
- A compound return is the rate of return on the balance, or capital, of an investment over a cumulative amount of time.
- Compounding returns effectively ensure that volatility in the financial markets–either the inflation or deflation of an investment portfolio–is fully accounted for when calculating the value of the portfolio.
Doing the Investment Math on a Compound Return
Most examples that calculate compounding returns start with an easy round number like $1,000. So let’s imagine that $1,000 is invested once a year for five years at a 10% rate of return.
- Year 1: $1,000 x 10% = $1,100
- Year 2: $1,100 x 10% = $1,210
- Year 3: $1,210 x 10% = $1,331
- Year 4: $1,331 x 10% = $1,464.10
- Year 5: $1,464 x 10% = $1,610.51
Doing “the math,” it appears that the initial $1,000 investment generated 10% growth annually, compounded over the five years.
But did it?
How can investments receive compounding returns every year if the financial markets dip or the market doesn’t perform to forecast? The beauty of compounding returns is that any pattern of growth (increases, decreases, or typically, a mix of both) resulting in the final investment value of $1,610.51 always translates into a 10% annualized compounding return.
Average Returns is an Imprecise Formula
The math behind compounding returns allows for a precise calculation of investment values, whereas other formulas like average returns offer an incorrect calculation.
If the example above is calculated using an average return formula, and no earnings in the first four years, followed by 61.1% growth in year five, the math looks like this:
- Year 1: $1,000 x 0% = $1,100
- Year 2: $1,100 x 0% = $1,210
- Year 3: $1,210 x 0% = $1,331
- Year 4: $1,331 x 0% = $1,464.10
- Year 5: $1,464 x 61.1% = $1,610.51
- Percentages of Years 1-5 divided by 5 equals 12.22%.
The Hidden Beauty of Compound Returns: Principal Plus Interest
Another powerful thing about compounding returns is the ability for investment growth based on the value of the principal plus the gains (the gains are the interest growth generated on the principal amount.)
Other income-generating investments like compound interest investments work differently. For instance, investing in a bond that pays compound interest means that the investment holder pays out (usually by check) the value of the interest generated at a particular time (generally either quarterly or annually).
Compounding return investments generate more investment income over time, by taking the gains (the interest made on principal) and adding or reinvesting it with the principal amount.
And the next time (quarterly or annually, depending on your investment terms) that the return on investment is calculated, the new investment value serves as the basis for the calculation.
Take the Long Way Home with Compounding Returns
Compound interest investments are appealing in the short term because of the quarterly or annual interest payouts to investors. For short-term investors, compounding return investments seem less attractive.
The truth is, compound returns offer the best investment opportunities to long-term investors–their value of a compounding return investment isn’t as spectacular in the short term.
How Can Investors Receive Maximized Compounding Returns at Retirement?
The most important thing to consider with compounding returns is to start investing as young as possible.
Many younger people in their 20s have financial obligations on their plates—everything from student loans, car payments, mortgage payments, and credit card bills. Perhaps it seems impossible to think about putting money away for retirement at the beginning of adult life.
But the following investor scenarios paint a clear picture. People who start an investment portfolio as early as possible see the maximum growth on their compound return investments.
In these three scenarios, each investor takes $120,000 in total principal and invests the principal over ten years. The annual compound interest rate of 7% is also the same in all three scenarios, and each investor reaches their retirement age at 65.
The only thing different in these three scenarios is the age of the investor when they started to invest:
- Investor 1 begins investing at age 25, investing $1,000 per month over ten years at an annual compound interest rate of 7%. At age 65, the value is $1,444,969.
- Investor 2 begins investing at age 35, investing $1,000 per month over ten years at an annual compound interest rate of 7%. At age 65, the value is $734,549.
- Investor 3 begins investing at age 45, investing $1,000 per month over ten years at an annual compound interest rate of 7%. At age 65, the value is $373,407.
The difference in value is pretty staggering.
Trust in Time
As the investor scenarios above prove, the most powerful tool in maximizing compounding returns is time—pure and simple.
The financial markets are in constant fluctuation, at the mercy of worldwide economic variables that can dramatically affect how much an investor receives in their compounding returns. The value of individual stocks or bonds will increase or decrease, thereby affecting the balance of an investment portfolio.
What a Compounding Return Product Must Do
Investments (also called financial products, or assets) that offer compounding returns must meet this essential criterion:
- When the product or asset sees a positive rate of return, investors must receive these gains in the form of interest payments or dividends.
- The value paid to investors can’t be another asset that only produces value when it’s
- The investment holder (generally the company that owns the product invested in) takes the investor’s payout or dividend and reinvests it in the underlying principal amount used to calculate gains.
- Alternatively, the gains are reinvested in asset holdings, basically a collection of stocks in the same investment portfolio.
Compounding Return Products to Choose From
The following products or assets are good examples of compounding return investments.
Mutual Funds are perhaps the most common funds to offer compound returns. Generally, the compound return format happens when the fund invests in stocks that pay dividends. The dividends are used to buy more shares of stocks, in turn, the investor owns more shares.
Exchange Traded Funds (ETFs) another common fund to offer compound returns, ETFs also invest in stocks that pay dividends. ETFs buy more stocks with shareholder dividends, and the investor payout continues to grow each time an ETF reinvests.
Certificates of Deposit are investment assets issued by banks. Certificates of Deposit pay fixed interest rates that are compounded on a schedule, with a specific date of maturity. Although it sounds a bit different, this investment works almost identically to an ETF.
How Can Investors Receive Compounding Interest through Work?
It’s good to check out an employer’s tax-advantaged retirement plans, like a 401(k) or a 403(b) when these plans are offered. Investing in a retirement savings plan through an employer means saving money on a before-tax basis.
No taxes are paid on a retirement plan until age 65 or later for a reason (generally, income and taxable income levels are both lower after retirement).
Compounding Interest Investments Versus Risks
There are always risks in investing, especially in stocks, and history’s most infamous and devastating stock market crashes crippled millions of investors and businesses worldwide for years. But facts are facts, and studies show that stocks (the riskiest parts of any investment portfolio) went up in 75% of the years tracked since 1928.
Thank You for Learning About Compounding Returns!
Investing in compound returns requires a degree of faith, but a qualified financial advisor is always advisable to maximize returns based on investor profile and market knowledge.
A financial advisor might not be able to read the market like a fortune teller, but they can be a powerful asset in managing the health and diversity of an investor’s portfolio.