A reminder about the power of compounding

Matt Richardson

I came across a great article written by Pete Wargent a couple of weeks ago which reminded us about the 8th Wonder of the World – Compounding Returns!

Some things about compounding don’t appear to make any logical sense on face value. When the value of an investment doubles at regular intervals, the increase in the value of the portfolio at each interval totals more than all previous gains!

As you can see from the example below, a portfolio which doubles in value every 7 years by earning an annual return of 10.29% will increase in value by $3.1m in the first 35 years and then $3.2m in the last 7 years!

Year Portfolio Value
0 $100,000 (starting value)
7 $200,000
14 $400,000
21 $800,000
28 $1,600,000
35 $3,200,000
42 $6,400,000

Seeing how these gains can accelerate when left to grow unimpeded by capital gains tax and transaction costs should draw investors to 2 conclusions:

  1. It’s best to start investing early; and
  2. Investing in assets which you never have to sell can be very appealing.
Examples of suitable assets may include:
  1. an index fund;
  2. a Listed Investment Company (LIC) with a low management expenses ratio which invests in more than 100 profitable and dividend-paying industrial companies. A typical example which is regularly endorsed is Australian Foundation Investment Company (ASX Code: AFI);

Starting early

Building wealth is reliant upon 3 things:
  1. Having some capital to invest;
  2. The ability to command satisfactory returns consistently; and 3. Time (and patience) to allow the portfolio to compound.

5 real practical tips

  1. Starting small is OK – do not procrastinate, start now! If starting small beware of transaction costs, which if purchasing shares can be minimised by taking the time to establish your own on-line broking account.
  2. Forced saving is good – have an amount deducted from your regular pay to a separate bank account for investment purposes only, or arrange for a regular direct debit to add to your investment.
  3. You don’t miss what you never had – same as Tip 2. If the money never goes through your hands before you invest, you won’t miss it. It is all about discipline!
  4. Reinvest gains – each time the income is generated (whether it be rent, dividends, interest or distributions), reinvest the proceeds. This is compounding! (Read: The Richest Man in Babylon – George S Clason).
  5. Most people aren’t very good at saving – unfortunately this is true – due mainly to a lack of discipline and bad habits. Saving is like anything you want to be good at – it just doesn’t happen by itself. You have to train yourself to get into good saving habits.

This is just another reason to set up an automatic investment strategy.

The team at Green Taylor Partners can point you in the right direction to get you started.