In the world of investing, among a seemingly endless variety of complicated systems, stands one simple but powerful concept. It's one that when mastered and correctly applied can contribute more to creating wealth for the average investor than perhaps any other: the power of compounding.
The secret to the power of compounding is instead of growing arithmetically it grows exponentially, as long as you do one very important thing: instead of spending the returns on your money, reinvest all of it. It works like this: say you invest in a bond that pays 5% a year with $10,000. At the end of 12 months, the bond matures with a value of $10,500. If you spend the $500, you're left with $10,000 to roll over into another bond at the same rate. But if you roll over the entire amount, at the end of the year, that $10,500 bond will have earned $530 and grown in value to $11,030. In the third year, rolled over at 5% again, earns $550.
Zoom forward 20 years, with the bond earning 5% every year. By rolling over principal and interest, your investment will have more than doubled in value to $26,530, without ever contributing any more money. You've collected $6,350 more in interest than the saver who spent all the interest he earned each year.
Danger: Suffering Big Losses
Although the advantage of compound returns was illustrated with an interest-bearing investment, the same applies to a stock portfolio by reinvesting any dividends or realized capital gains. But when it comes to investments like stocks whose prices fluctuate, it's essential to avoid large losses if you want to maximize the power of compounding.
Whenever an investment position loses money, you need a larger gain than the percentage lost to return to its prior value. The chart below makes this clear:
% loss |
% gain needed to recover loss |
1% |
1.01% |
5% |
5.26% |
10% |
11.11% |
20% |
25.00% |
30% |
42.86% |
50% |
100% |
When an investment (or a portfolio) loses less than 5% in a year, it doesn't take very long to recover your losses, because on average, stocks return between 9% and 10% a year. As a result, you can expect to wait for as long as several years or even more to recover from losses that are greater than 20%. And since compounding gathers power over time, such delays can be costly.
What's more, big losses can tempt you to try to recover more quickly by choosing higher-risk investments, which exposes you to the possibility of further and deeper losses. The moral of the story is, the less volatile your portfolio returns are over time, the more you will benefit from the power of compounding through the reinvest of your returns.