Saturday, March 21, 2009

What is compounding?

Compounding is one of the most important concept that the new investor must understand. It is fundamental because it is the behind one of the investing strategies that is most used: The buy and hold strategy.

To start lets talk about the maths. If you start with a certain amount P the principal and you invest this money at an interest rate I for a certain amount T then the amount that you will get is given by the formula

amount = P x (1+ i/100)^T

For more details see my post on interest rate here.

For the purpose of this post i have compiled the table below that shows the return of three persons investing in different conditions. All three are buy and hold investors and as you can see the returns are different.

Name Start End Initial amount Interest rate Amount at 65
Anne 20 65 10000 10 728900
Jack 30 65 10000 10 281000
Paul 20 65 10000 9 483200

We can thus deduce that three conditions must be present for you to maximise your investments.

1. Time

The person must invest as early as possible. As you can see from the table Jack and Anne started investing at different age. The 10000 dollars of Anne were invested for 45 years while that of Jack were invested for only 35 years. This difference of 10 years results in the investment of Anne to be almost double that of Jack.

One advantage for Anne, as you can see from the graph above, is that after some time the increase in value will accelerate and at this point you can stop investing or at least you can reduce your monthly contribution. While Jack and Paul have to increase their contribution just to reach the level of Anne.

2. The rate of return

As you can see from the table if two persons invest with a difference of just 1 % in the interest rate then you can have a large difference in the amount of money at 65 years. Both Anne and Paul started investing at 20 years of age but one at 1o % and the other at 9 %. This will show to you the difference of just 1 % difference in the interest rate. That is what will happen if someone invest in a mutual fund that take 1% return or if you buy and sell often and the broker take 1 % commission. With time as you can see you return will be greatly reduced.

3. Reinvest interest and dividend

It may not be obvious from the graph but the compounding work only if the earnings are reinvested every year. So guys do not use those interest and dividends.

I hope that this post will have shown to you the advantages of buy and hold and the merits of compounding.

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