Compounding is often a term that comes up when people are discussing money and investing. It is also one of those terms that many aren’t quite sure what it means or even how powerful it can be to make your money do the hard work for you. We will look over why it is one of the best reasons to invest.

**What is compounding? **

Compounding is when you take a number and increase it over and over again by a percentage, say 10% annual growth. It can be thought of as “interest on interest.” In contrast, increasing your original investment by a fixed number, say add 10 each year, is known as your simple return. The result of compounding is much larger growth than what could be achieved with interest on the original investment alone. That’s the magic.

There are two main ways compounding can make a difference when it comes to money: compound interest and compound returns.

**Compound interest**

Compound interest is when you hold a savings/deposit account which has an interest rate. To illustrate, if you have a savings account of €10,000 that pays 3% each year, then your investment will increase by 3% every year. You have the decision to leave the €300 in the bank, or take it out and buy something. If you take it out, then wait another year you will receive another €300 in interest on your original investment.

What if you decided to leave the interest in the bank account? You would start the second year with €10,300 in the bank. At the end of the year, you would have €10,609. So you will receive an additional €9 in interest on the €300 interest that you received in the first year. It does not seem like much after two years, but if the interest was left in the account, then you would earn interest on your original investment, plus interest on the interest earned in your first year, plus interest on the interest you earned in your second year. So it carries on then over the years this could accumulate to be quite the impressive amount.

If you left the €10,000 in the bank for 30 years, you would have €24,200 in total. When you minus the original investment an amount of €14,200 is due to the interest, €9000 relates to interest on the original and another €5,200 relating to compound interest. Pretty cool that this is just for letting your money sit in the bank for a while.

**Compound returns**

The concept of compounding returns is the same as compounding interest—by leaving your money invested; you start to earn returns not just on your original investment, but on the returns you made along the way. Compounding returns relates more to the stock market, and it differs because you are not earning interest, which is a promised, steady amount — you’re potentially earning investing returns (dividends and growth in price), which are not guaranteed nor can they be relied on consistently. They do have amazing upside potential.

**Reinvesting dividends**

A great way to get compound returns is to reinvest dividends by using the amount received to purchase shares so that there is an increase in the number of shares held. It will lead to a rise in the dividend received for the following year.

**Growth in share price**

Not all investments pay dividends, so the other way to get compounding returns is through the fluctuations in the price of investments. The returns here are not as apparent as the scenarios above but is definitely still there. When the value of the investments you own, like stocks and bonds, increases (or decreases), that makes the balance in your investment account increase (decrease). As long as you leave the difference invested rather than withdrawing, then your returns have the opportunity to compound over time.

If the market was to increase for a good amount of time then with the money you had invested, compounding would work in your favour. Of course, the market works the other way too, if markets were to decrease, then the value of your investment would also decrease but this is part of the risk. The longer time horizon you have, the more likely you are to have overall positive returns.

To illustrate, below is the five-year S&P 500 index (US 500 largest companies), as you can see over the last five years, there has been ups and downs in the index but an overall upward trend.

**S&P 500 Index - 5 year price movement**

**Compounding returns and regular investments**

This is known as __dollar-cost averaging strategy__ which spreads out your share or investment purchases by buying at regular intervals and in roughly equal amounts. It can be great for compound returns because you’re giving your money more and more opportunities to earn returns.

The best way to see the magic of compound returns is to investigate it for yourself. Take a look at __Money’s Chimps compounding returns calculator__ and run a few different scenarios. Make sure you include an annual additional deposit to highlight the differences in the end investment value.

Further on, an easy way to estimate the effect of compound interest is the ‘Rule of 72.’

The Rule of 72 estimates how long it will take you to double your investing with only using the annual return on your investment.

For example,

At 8% interest, your money takes 72/8 or 9 years to double.

To double your money in 15 years, get an interest rate of 72/15 or 4.8%.

You will see why investing can be more useful than simply saving and what a difference it makes with time on your side and to make regular investments.

*Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up. *

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