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Wednesday, August 4, 2010

Compound interest

After 16 years in financial planning there are terms and concepts that I just take for granted, but on my first day on the job somebody even had to tell me what was meant by “equities”. Pity the person that had to enlighten me on the topic of dividend imputation :). So what’s the point of this particular ramble? Only that a friend of mine asked me recently to explain the principle of compounding, and I realised that sometimes we financial planners assume that everyone knows what we’re talking about!

For those of us that like to maximise our investment returns, compounding is actually very important. Sometimes it’s the small things that can make a big difference.

When you earn income from an investment you have two choices – you can either have the income paid out to your bank account, or you often have the option to re-invest the amount back into your investment. The investment could be shares, a managed fund, or a Term Deposit, and the type of income could be dividends or interest.
Compounding works when you re-invest the income instead of having it paid out to your bank account. If you continue to do this over a few years, you'll be earning interest on your interest on your interest, which results in a better return than paying out the interest and dividends to a bank account.
Let’s take a really easy example of an investment of $100,000 earning 10% per annum for three years.

Scenario 1 – income is paid out at the end of each year:

Initial investment - $100,000

End of year 1 - $10,000 is paid to your bank account;

End of year 2 – You still have your original $100,000 invested so you receive another $10,000 income;

End of year 3 – Again, you have your original $100,000 invested, so your receive another $10,000 income;

At the end of three years you’ve earned $30,000 interest on your original $100,000 giving you a total of $130,000.

Scenario 2 – income reinvested and compounded

Initial investment - $100,000

Year 1 - $10,000 is re-invested, so that you now have an investment of $110,000;

Year 2 – Income of 10% on $110,000 is $11,000 which is re-invested so that you now have an investment of $121,000;

Year 3 – Income of 10% on $121,00 is $12,100 which is reinvested to give you a total of $133,100.

So after 3 years you’re more than $3,000 better off simply by compounding your interest each year instead of having the money paid out to you.
And that folks, is compounding, pure and simple.

Talk soon,

C xx