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Compounding your returns is nothing new to investing; it is a basic “tool” and if like me, you had a love of maths as a child, you may even remember studying it at school. Albert Einstein called it the most powerful force in the universe.
Compounding is the process whereby returns are reinvested so that they then generate returns of their own, which are reinvested and make returns of their own. Think of it as a snowball effect.
You can reap the rewards of compounding in your share or managed fund portfolio through two investing concepts … Reinvesting your dividends/distributions … and also … Making regular additional contributions.
Case Study 1: Burt and Ernie both invest $100,000 for 20 years with a guaranteed return of 7%. Burt lives for the here and now, so opts to receive his $7,000 in the bank each year and spends it on everyday lifestyle expenses. Ernie is after maximum returns and reinvests the returns every year. Have a look how they turn out:
The same investment has yielded over double the result for Ernie, simply because he did not spend the returns, but reinvested.
Compounding can work even harder for you if you also add additional regular contributions, say each month.
Case Study 2: Athos, Porthos and Aramis all invest $10,000 with an expected return of 8% per annum. Athos does not add to his investments. Porthos contributes $100 monthly and Aramis contributes an additional $200 monthly. Results are as follows: