The idea of compounding interest is a vital and fascinating concept that is part of the very fabric of investing.
They say money doesn’t grow on trees. But if we really think about it, the trees, its fruits and the seeds within it make an interesting analogy for one of investing’s fundamental pillars – compounding returns.
What is a compounding return?
Imagine you have a plot of land to build an entire orchard of apple trees. And you have ten years to do it. But there’s a limitation: you only have a single seed.
The seed has one special quality – If you plant and nurture it, you get an apple tree and two new seeds each year. And planting these new seeds bears the same result – an apple tree with two new seeds each year. To maximise your chances of creating the orchard, you’d plant all these seeds, right? So let’s say that you do.
After two years, you would have a total of 9 seeds. How? The one you started with (remember that it is still producing two seeds a year because you keep nurturing it), the two it produced at the end of year one, and the six that they produced at the end of year two. Plant these new seeds and repeat this process, and in 10 years, you would have 59,049 seeds. More than enough for a vast orchard. All from a single seed.
In the analogy above, the first seed is your principal investment, and sowing it is the act of investing. The seeds you receive as a result of staying invested for a year are your returns. Sowing these subsequent seeds is the same as reinvesting your returns.
That’s when compounding comes into play. When you reinvest your returns, they can generate more returns. When this cycle continues, wealth has the potential to grow exponentially. Just like your orchard.
The interest rate can be calculated as the percentage of the principal gained at the end of a given period. Since every seed you planted produced 2 new seeds at the end of a year, the interest rate is an astronomical 200% per year. A fine number to illustrate the power of compounding, but an unrealistic expectation to have from any real-world investment.
But wait, why do we receive compounding returns?
In the world of banking and investing, returns can be thought of as the compensation one can expect for financing someone else’s needs (and assuming the risk that goes with it). Returns come mainly in two forms:
- Interest – a regular payment made to the lender by the borrower
- Price appreciation – when the price of what you invested in increases over time
Sometimes the two go hand in hand. Either way, for compounding to occur, the returns you gain must be reinvested.
For example, when you buy equities, let’s say shares in Apple, your compounding returns come primarily from the fact that the value of the company tends to go up over time. And from time to time the company may pay dividends.
Bonds typically pay regular coupons (i.e. interest) that you can reinvest. However, their prices also fluctuate over time, which means you could gain returns by selling them at a higher price than what you paid for them.
Time, odds and patience
For most investments, compounding tends to have a greater impact over the long term (think about the size of your orchard in just 10 years). Therefore, it is considered wise to hold onto investments for a long period of time. However, it is also not the only aspect you should consider. To demonstrate this, we ran a quick analysis on the Dow Jones (an index representing the performance of the top 30 US companies). The results show that increasing your holding period tends to reduce your chances of losing money and skew the risk-return profile in your favour.
Of course, there are a few caveats to this example that we need to highlight for the sake of intellectual honesty:
- First, compounding is not magical. Picking the wrong investment could mean not receiving any returns (not even the longest holding period can help if the company you invested in goes bankrupt!). The first step is to do your research and pick investments wisely.
- In our example, we picked a diversified index of 30 companies. That helped because the returns from high performing companies largely compensated for the returns from low performing companies (not to mention the fact that indices are subject to survivor bias, i.e. only the best-performing companies stay in the indices over time). Running this analysis on any individual stock would yield different results.
- Finally, this has worked primarily because the US economy and the price of the index have grown over time (at an average rate of 5.3% per annum over that period). But one can easily argue that, first, there can be a long time where that might not be the case (take the post-depression period, for example) and second, not all economies have been as robust as the US economy.
The idea of compounding interest is a vital and fascinating concept that is part of the very fabric of investing. If you’re curious to learn more about investing, we have a 10-day email Masterclass that covers all the basics for investment success. And it’s free.
Disclaimer: Alpian has submitted an application for a full banking license to Switzerland’s Financial Market Supervisory Authority (FINMA). Content of this publication is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.