The power of compounding interest explained

As Benjamin Franklin put it, “Money makes money. And the money that makes money, makes money.”

We are often told that investing is the way to make our money work harder for us. How exactly does our money work harder when we invest it? The answer is quite simple: compound interest.

The power of compound interest

Compound interest is the return earned not just on your principal, but also on the gains that the principal accumulates. Put differently, if you earn returns on your investment, then those returns can also earn additional returns when reinvested. Compound interest results in exponential payoffs because the returns portion of your portfolio generates more money, again and again.

How to calculate compound interest

Assume you have $100,000 today, which you invest in a portfolio that averaged an annual return of 5%. In a year, that $100,000 would earn $5,000. If all those portfolio gains are reinvested, you would earn $5,250 in the second year, $5,512.50 in the third year, $5,788.13 in the fourth year, and so on.

But your investments can only benefit from compound interest when the returns are reinvested. Had you withdrawn all the returns you earned on your $100,000 investment, you would only be earning $5,000 each year.

In the short term, the impact of not reinvesting returns may seem insignificant. But wealth building takes time, and if we extrapolate those returns over 30 years, there is a massive disparity in wealth between an investor who reinvested their returns and an investor who did not.

When reinvesting returns, your initial $100,000 investment grows to $432,194.24 (or 4.32 times what you started with) over 30 years.

On the other hand, your investment would only grow to $250,000 (or 2.5 times what you started with) if you withdrew your returns, which means you lose out on almost $182,000 by not reinvesting your returns.

In essence, compound interest acts as the accelerant for your investments. With it, your wealth grows quicker, bringing you much closer to your financial goals — provided that you start investing early and leave your investments alone for long enough.

Time: the biggest factor in compounding interest

It is a given that compound interest is a simple and powerful way to grow wealth, but for it to really pay off, you need to give it time.

Consider the average person’s dream of becoming a millionaire, how can compound interest and time help them achieve their dream? The earlier you start investing, the less effort is required on your part to become a millionaire.

It only takes monthly savings of $314.11 for you to be a millionaire by 65 if you started investing at the age of 25 in Endowus’ balanced portfolio that returned 7.64% annually. But waiting till you are 40 to begin investing would mean that you need to save $1,107.39 every month to hit $1 million.

Based on the age you start, here is how much you would need to save and invest every month to become a millionaire by 65:

Because you need time for compounding interest to really work its magic, you would also need to put more of your money to work if you start investing later.

Starting at 35 means having to save more than twice as much money as if you were to start at 25 — to get to the same goal of retiring with $1 million.

When you are young, time is on your side. Adopting a regular and consistent savings habit early in your adult life, especially when you have no financial obligations, ensures that you will sail smoothly through the years to come.

Even if you did not start saving and investing at 25, it is not too late. It is better to start anytime than not at all. As the saying goes, the best time to invest may have been 20 years ago, but the second-best time is now.

Start investing early to take advantage of the power of compounding

If you are saving for your short-term goals, do not let your savings sit in a bank account earning abysmal returns. Instead, consider moving some of your savings into an account that can, at the very least, earn a return that keeps up with inflation.

You may assume that a small difference in returns would not really make a dent in one’s wealth. On the contrary, just an additional 1% in returns can make a massive impact on how much money you will end up with over the long run.

$100,000 in an account that earns 1% annually would only grow to about $148,886 in 40 years. What happens if that money was moved to an account that earned 2% a year?

You would have $220,803, or almost $72,000 more than leaving your money in the account that yielded 1%.

But if you are not planning to use that money any time soon, it will serve you better to be invested in a portfolio that can generate greater returns over time. Every day you sit on cash is a day you miss out on the opportunity to compound your wealth.

With a 7.64% average annual return, a $100,000 investment will grow to a whooping $1.9 million in 40 years.

While compounding grows your money regardless, it will grow much more quickly in an investment portfolio that offers better returns than a regular bank account.

Stay invested for as long as possible

When investing, it can be tempting to cash out when the market goes down, or even sit on cash in an attempt to time the market.

But the snowball effect of compounding only works when you have the mental fortitude to sit through market events without touching your investments. It is essential to keep in mind that investing is about playing the long game. While your portfolio's value will rise and fall in the short term, ultimately, it is better to stay invested than leaving your cash to erode to inflation.

Besides, no one can time the market correctly all the time. On the other hand, history has shown that the stock market tends to rise over a longer timeframe. It is best that you stay the course for as long as possible.

Do not underestimate the impact of fees on your returns

Just like investment returns, your investment fees also compound over time. But instead of helping you build wealth quicker, fees have the opposite effect — they eat away at your hard-earned savings.

Though it is almost impossible to escape investment fees altogether, there are investments with lower fees so that the impact on your returns is minimised and you keep much more of your returns.

The traditional fund manager has a ~2% annual management fee while the digital fund adviser charges a ~0.5% management fee. If both investment vehicles yielded a 5% annual return before fees, a $100,000 investment would lose more money to fees — around $134,555 — with the traditional fund manager compared to the digital fund adviser after 30 years.

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What it really means to make your money work harder for you

Conceptually, it is fairly easy to grasp the effect of compound interest — start early, put your money in a vehicle that earns reasonable returns with low fees, and stay invested for as long as you can.

But human nature and life are such that it is not that easy for most people to take advantage of the most powerful tool in investing.

While it is natural to veer off course on your financial journey from time to time, it is important to come back to your plan as much as you can. To do that, take stock of your investments from now and then, adjust your investments to fit your current life situation if you need to, and remind yourself why you are investing in the first place.

Whatever goals we hope to achieve — financial freedom, paying for our children’s university, early retirement, and so on — it pays to make our money work harder for us right now to help us get there faster.

To get started with Endowus, click here.

Next on the Endowus Fin.Lit Academy

Read the next article in the curriculum: The bulls and the bears: what are market cycles?

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