Einstein famously said that compound interest is the most powerful force in the universe. And when comparing against things like gravity, that’s quite a statement.
'... Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it...' - Albert Einstein
Your short-cut to long-term success
Fortunately, you don’t need to be as smart as Einstein to understand the concept of compounding yourself, or to reap its huge potential benefits. Through a simple and mechanical process, you too can generate exponential investment growth over time.
The concept itself is actually pretty simple. Compounding is what happens when you take a number and increase again, and again, and again by a percentage. For example - you take a number, and then you increase it by 5%, and then another 5%, and then another 5% etc. That’s opposed to increasing a number by another fixed number (e.g. you take a number, and then you add $5, then add another $5, then add another $5 etc).
The magic of this is that, with compound interest, you earn a return not just on your original investment, but in later years you also earn a return on your previous returns. It means that the actual dollar amount of your return, each year, can actually increase over time.
For example, in the first year you’ll earn a return on your investment. In the second year, you’ll also then earn returns on the returns. In the third year earn returns on the returns on the returns. And... this just keeps on going forever. Your returns get bigger and bigger in absolute dollar terms, despite being the same in percentage terms
Compounding returns = Reinvesting dividends
So what does this mean in practical terms? Well, when you invest in a company on the stock market you’ll receive dividend payments each year. These dividends are a share of the company’s profits, and they are passed back to investors because investors are the ultimate owners of the business.
Investors then have a choice - you can either withdraw the cash and spend it or you can reinvest these dividends back into the company. Spending the dividend might be appealing (who doesn’t like spending money…) but reinvesting the dividends is the way for you to reap the benefits from compound growth. If you reinvest the dividends it means that you’ll be able to grow your investments on a percentage basis, as per the magic of compound interest, whereas if you spend the dividends it means you’ll be locked in a world of lower, absolute interest.
And the effects really are magical. If you’d bought into the S&P 500 Index in 1950 and held it until 2020, but spent all your dividends, your return would have been 22,241%. This doesn’t sound too shabby. However, your return would have jumped to a whopping 213,528% if you’d also reinvested your dividends. In other words, since 1950 about 90% of your gains would have come from reinvesting your dividends and reaping the exponential growth of compound interest.
Earning it... or paying it
Whilst compound interest can be harnessed for good, the flip side is just as powerful - high fees that reduce your returns have an ever increasing effect over time.
This is brilliantly displayed in a tweet from The Dividend Growth Investor which showed that:
'... If you invested $1,000 in Berkshire Hathaway in 1965, by 2009 your investment would have been worth $4.3 million.
If Buffett had set up Berkshire as a hedge fund, and charged a 2% annual fee plus 20% of any gains, the investor would have been left with only $300,000… '
That’s a 10 times difference, just because of the negative impact of compound interest combined with high fees!
The easiest way to earn it
Reinvesting dividends by yourself can often be time-consuming. Sometimes, the additional trading-fees charged from your stockbroker might make it too costly to be worthwhile. Or you might not be able to invest your dividend at all because of the lot-size issue with ETFs here in Hong Kong.
If this is the case for you, then look out for ‘Dividend Reinvestment Plans’ (or DRIPs) which some stock brokers have started to provide. These help you automatically reinvest the dividends you receive from your stocks each month, meaning that you don’t have to worry about missing out or paying additional fees.
At Teyk, we’ve created the ultimate technology-driven investment platform, and we include automatic dividend reinvestment at no extra cost