How to Level-Up Your Savings with Compounding Interest
If you were to ask Warren Buffet what the single most powerful factor in a successful investment plan was, without skipping a beat, his answer would be ‘compounding’.
Compounding interest and time are your best bets for making fantastic returns in the long term. There is simply no better alternative.
Compounding interest earns you extra FREE money.
When you earn a return on your investment, many people, perhaps most, think of this in % return. You invest $100. You make 20%. By the end of the year, your $100 is now worth $120.
Compounding is not only about earning interest but earning interest on your interest.
Take the above example but for the next year.
$120*1.2 = $144. Oh, wow! Just check that out.
The first year, I made $20 on my investment, that’s when $100 went to $120.
But with the same 20% return the next year, I have made $24 ($44-$20= $24). That extra $4 is interest earned on your first year’s interest.
When applied to investing, compounding is like the proverbial snowball that is rolled down a hill. It starts small but slowly gathers more snow with each roll. Then, very soon, that little snowball is a very, very large snowball: a SNOW BOULDER, even!
You might want to think about this when you are investing for your children or your retirement.
The following table shows $10,000 invested at 7% return over 10-year increments, through to 100 years from the time of investment.
That’s the magic of compounding!
Do you see the doubling of your return every 10 years?
At 7% return, you will double your money every 10 years. At 10% return, you will double your money every 7 years—it’s a helpful little rule of thumb.
Compounding is the key, and over the long-term, compounding will outsmart, outcompete, and outdo any trader, investor, or alternative investment approach.
Compounding gets better and better over the long term – it always wins!
The key components therefore are:
- time
- initial investment
- interest
Compounding with dividends works well.
Many stocks earn dividends (a small percentage that the company hands out to shareholders of the company), but with a large holding, that small percentage can mean an awful lot of money.
To turn your dividends into compounding magic, reinvest your dividends into the same stock.
That cash, instead of being spent, gets automatically reinvested.
Consider an investor that receives a cash dividend on his shares. The investor fully participates in a dividend reinvestment plan, otherwise known as a DRIP. I know, great name, right?!
DRIPs help investors achieve compounding returns. But the investment scheme is no drip!
Because for each dividend payout, the investor will receive more cash dividends due to the additional shares purchased through the DRIP.
The cycle of reinvestment compounds the investor’s returns and increases the return potential.
Anybody can take advantage of compounding interest with these 5 tips.
- Set aside a lump sum of money. Ideally, this would be the highest amount you could afford. Do some research and find the safest return. Diversified asset base would be the most sensible – perhaps invest on the S&P 500. Leave the funds invested there for as long as practical.
- Don’t touch them! Be patient.
- All income produced by this investment—reinvest.
- If you have spare cash—reinvest.
- If you CAN afford to, regularly place a small additional contribution—reinvest.
The point is that continual compounding of returns will have a massive positive impact on your earnings.
In fact, at some stage, the compounding takes over as your primary money earner.
Don’t believe me? Check this chart out.
It’s easy to see that by year 12, compounding interest takes over as the primary earner. By year 20, it’s just astonishing.
Don’t forget…
- Invest early—the real magic of compounding is only realized over time.
- Invest in a safe long-term earner—companies tend to have shorter survival than you might think. Diversity is your friend; an index is a good approach here.
- Invest consistently—Set aside a certain amount of money regularly. Think of it as a tax on yourself, but one where you get the benefits.
Remember, compounding works. Start early enough, and you will win!
Want more advice on saving strategies? Sign up to my email newsletter below and stay up-to-date.
This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
MORE INSIGHTS FOR YOU
Who is Paul Atherton, That Wall Street Guy?
An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.
AS SEEN IN THE MEDIA
