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COMPOUNDING or compounded interest is no new term in the investment world and the concept has been around for many years. Compounding has been called the 8th wonder of the world by Albert Einstein and praised by Warren Buffett and Benjamin Graham as a very powerful investment principle.
Regardless, many modern-day investors forget or ignore this powerful principle. Many investors spend away their investment returns, significantly decreasing their portfolios return over time.
Warren Buffett described compounding in one of the letters he wrote to his investment partners as “the most powerful tool in the creation of wealth through investment”. Compounding or compounded interest can be defined in simple terms as interest on interest.
Compounding occurs when the returns on an investment portfolio are reinvested to generate its own returns. The result over time is like a snowball effect, where the portfolio starts growing quicker and quicker, the longer it’s invested.
The catch is that the wonders of compounding require patience and time, two things which scare many modern day investors who operate and live in a world where everything is instant and everyone is looking to make a quick buck. Nonetheless, the returns that compounding creates over time is worth the wait.
The table below illustrates the powerful effect compounding can have on the investment returns of a portfolio:
The table shows the gains of two portfolios called the compounder and the spender. The compounder reinvests all the gains and the spender portfolio spends all the gains.
Assume an investment of R1m at 10% over 10 years. After 10 years the gain on the compounder portfolio will be R1 593 742, compared to the spender's gain of R1m.
The compounder’s portfolio’s gains are roughly 50% higher than the spender portfolio’s gain over this 10-year period. The difference in the two portfolios' gains will become even bigger as the investment horizon increases.
Over a 20-year period, the compounder's portfolio gain is R5 727 500, compared to the R2m gain on the spender’s portfolio. This is almost three times the gain of the spender’s portfolio.
Compounding can significantly amplify returns over time. When comparing the gains of a compounder portfolio earning 5% and a compounder portfolio earning 10% over a 5-year period, the 10% compounder portfolio’s returns (R610 510) are little more than double the gain (R276 282) of the 5% compounder portfolio.
This is to be expected as a 10% return is double that of a 5% return. But looking at the same gains over 30 years, the return on the compounder portfolio earning 10%is more than double the return of the compounder portfolio earning 5%.
In fact, the return (R16 449 402) of the compounder portfolio is almost 5-and-a-half times more than the gain (R3 000 000) of the compounder earning 5%.
This shows how important it is to earn additional return, because over time even a small additional return can result in a big gain.
As illustrated, compounding can be a very powerful tool in the creation of wealth through investment and should be a key building block of any investment portfolio. Investors that have the patience and discipline will be rewarded significantly in the long term.
I leave you with the world of Benjamin Graham: “Those who understand it, earn it and those who don’t, pay it.”
* Werner Erasmus is the Gauteng regional manager of Overberg Asset Management
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