The Common Sense Investor

Compounding is the fact that the money you make off an investment can be reinvested to make even more money than your initial investment. The money you make goes back to work to make you even more money than before.

Sound confusing? It’s actually pretty simple.

Say you’ve invested $10,000 and it makes 10% interest per year. In the first year, you’ll make $1,000 in interest. But in the second year, you’ll make $1,100 (not only does your initial investment of $10,000 accrue interest but so does the additional $1,000 you made in the first year). In the tenth year, you’ll make $2,358. And in the 30th year you’ll make $15,864. That’s all without making another investment beyond your initial $10,000. In 30 years, the power of compounding gets you from making $1,000/year to making $15,864 per year. Pretty remarkable, huh?

You can magnify the results of compounding even further by doing regular investments. When it comes to building wealth the most effective way of amassing resources is to make regular and periodic investments and then reinvest your profits rather than spending them.

Following this simple rule can result in some surprising results. Take for example a man who decides to invest a portion of his income into an investment account of his choice every month and then commits to let that money ride. This means that he won’t make any withdrawals from this account until he has achieved his desired long-term goal. Let’s say he puts in $500 of his income every month.

Now, the overall market, as measured by the S&P 500 index, returned an interest of 11.8 per cent on average every year for the last ten years. Let us assume that you can achieve the same return and you can earn about $114,000 after the 10 year period. But technically it is much more than that. You will actually have $486,000 if you stick with your plan for 20 years and about $1.7 million in 30 years.

The process being described here is a combination of two very effective investing strategies that have proven time and again to achieve successful results – these are compounding and dollar cost averaging.

But let’s focus on compounding here. First, let’s define compounding. It is, in its simplest definition, reinvesting rather than spending your profits. By following this simple strategy you benefit from the future returns of your reinvest profits as well as on your original investment.

Compounding as an investment strategy is deceptively simple. But in reality it is relatively hard to do because you, as an investor, will need a lot discipline. The key, really, is to not touch your profits, but to put them back to work.

For any investor, seeing his money building up in his account can be a big temptation. Many investors might think that it won’t hurt if they skim off the profits and spend it on their whims since they won’t be touching the principal amount anyway. In reality, this won’t really hurt your investment position but, again, based on the concept of compounding, if you leave your money (the principal amount and the periodic profits) safe in the account, the potential profits get exponentially larger.

You should look for investment options that have relatively low risk if you want to use a compounding strategy. The best way to avoid risk is to invest is strong companies with proven track records, low P/E ratios and high return on equity. The reason for taking a long-term, low risk stance is that you are aiming for consistent, long-term profit. Long term strategies are better paired with investments that carry lower risk and which make good investment sense. Just remember, you don’t have to sacrifice returns for low risk. You just have to do a little more work and find good companies at reasonable prices.

Finally, assess your investment options at least once a year and if you see one that is consistently underperforming transfer your money to another one that performs consistently better. But you must also remember that even the best investment options can sometimes undergo a period of underperformance. So even if you are advised to weed out underperformers don’t be too rash in your decisions. At the very least, reevaluate your portfolio every year or two to have a better picture of their long-term performance.