The power of compounding in investments
Joel Dresang: Dave, let’s talk about some mathematical magic that underlies successful investing and saving. Um, you were telling me that you were talking with your kids about this. Compound earning. What is it?
Dave Sandstrom: Joel, compound earnings and compound interest are probably the most significant and powerful tool you have available in your investment toolbox.
Essentially what it is, is allowing the earnings and the interest that you gain on your initial investment to reinvest so that what eventually happens is your earnings gain earnings, and then those new earnings gain earnings themselves. So you see that you have this compounding effect that, over time, becomes almost exponential in the growth of that portfolio.
Joel: So the money you set aside keeps building on itself?
Joel: Let’s look at an example.
Dave: So let’s take a $10,000 investment, and let’s look at a historical rate of return on a balanced portfolio of 8%. And let’s say that you left that in there for 30 years. You could turn that $10,000 into $100,000 by reinvesting all of the interest and dividends.
Joel: So over that 30 years, you went from $10,000 to $100,000, and you weren’t adding anything else to it.
Dave: That’s correct.
Joel: Let’s look at adding things to it.
Dave: So look at that last example, start with $10,000, but now let’s add $1,000 a year. Okay, so not only is your initial investment compounding but the $1,000 you put in each year will eventually start to compound. So now we go from $100,000 at the end of that 30-year period to almost $220,000. Pretty substantial difference.
Joel: How do we use this power of compounding to build retirement income?
Dave: As we look ahead to retirement and think about the earning potential, take let’s say, a dividend-paying stock or stock portfolio that, an average dividend of about 3%. If you had $100,000, obviously, you have $3,000 worth of dividends coming out of that account. Now let’s leave it in there and let that compound. With an 8% compounding rate, the portfolio will double every nine years.
And that $3,000 dividend payment now becomes $6,000. If we can let it in there for another nine years and let it double again, now we have a $12,000 dividend payment. The dividend rate is not changing but by allowing the portfolio to grow you’re obviously increasing your potential for income.
Joel: What kind of lessons do you want investors to take from this whole concept of compounding?
Dave: Well, it’s time in the market, not timing the market, as we like to say. So you can see over long periods of time, compounding has an even greater effect. So, leave it in the market. Don’t take the earnings out. Allow the compounding to occur.
Joel: What about for older investors who don’t have as much time in the market as, say your kids would?
Dave: Compounding still plays an important role, Joel. We’re living more active lives in retirement, we’re living longer, so it’s important that we leave a portion of those earnings in the portfolio to allow them to compound. So that it protects our principal and even allows it to grow, maybe to cover inflationary times, but more importantly to provide some growth in the long run.
Dave Sandstrom is vice president and advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted June 3, 2016)