What is compounding? All information about compounding
There is absolutely nothing wrong with working hard, but we live in a time nowadays where you can no longer get there with just hard work. Building wealth doesn’t have much to do with that these days. Nowadays you have to work smart. But how can you do that in the best way? In this article we explain how you can work smart on the basis of a mathematical phenomenon called compounding. So let’s start: What is compounding?
What is compounding?
Compounding is also known in the Netherlands as the ‘return-on-return effect’. In short, this effect means that you can generate new profits based on previous profits, and also generate new profits based on those profits. You basically let your assets work for you, without you really having to do anything for it. The effect is very similar to the well-known snowball effect. When a snowball rolls down a hill, it picks up more and more snow making the snowball bigger and bigger. The more snow the ball picks up, the bigger the ball gets. This is exactly the case with compounding.
Calculation example compounding
Suppose you start investing on January 1, 2022 with an amount of €100,000. During the first year, the share price rises by 20%, giving you a return of €20,000. Your investment is now not worth €100,000, but €120,000. In the second year, the share price also rises by 20%, so that you do not achieve a return of €20,000, but €24,000. So your investment has not increased in value by €20,000 in the second year, but by €24,000 because of your initial €20,000 in profit in the first year. Your investment is now no longer worth €120,000 or €140,000, but €144,000.
|Invested amount / starting amount||€100.000|
|Percentage increase in price in year 1||20%|
|Profit after year 1||€20.000|
|Value investment after year 1||€120.000|
|Percentage increase in price in year 2||20%|
|Profit after year 2||€24.000|
|Value investment after year 2||€144.000|
How does compounding work?
Compounding is an important element in investing. By fully exploiting the phenomenon, we can generate returns on our previously achieved results. A goal can very easily be linked to compounding. But the question then is how much compounding should we use to achieve our goal? And how can we best do that?
We can link a formula to compounding, namely the Compound Annual Growth Rate (CAGR) formula. This formula will tell you exactly how much return you need to achieve annually to achieve your goal. The formula is as follows:
Suppose your investment portfolio is currently €100,000. Your goal is to reach a value of €1,000,000 by age 60. You are currently 25 years old. So you still have 35 years to reach your goal. What return do you need to achieve annually to achieve your goal?
In order to achieve your goal, you must therefore achieve a return of 6.8% every year. This is of course an average, since you can be well below it one year and well above it another year.
The basics of compounding
The phenomenon of compounding is such a powerful concept that even Albert Einstein described it as “the eighth wonder of the world.” This phenomenon is able to put your money to work for you. To put this into effect, only two things are needed: time and reinvesting your winnings. The more time you give the reinvestment, the greater the gains on your initial investment will be. In addition, the sooner you start compounding, the faster you will reach your goal.
Below is a brief example based on the yield of 6.8% above. Fatima and Mark both want to save a nice amount of money through compounding. They each have a starting amount of €20,000. Fatima starts compounding at the age of 20 and Mark only starts at the age of 25. In the graph below you can see that at the age of 45, Fatima has achieved a much greater advantage than Mark. So you see again that it is certainly wise to start compounding early.
Does compounding involve risks?
Albert Einstein thought the phenomenon of compounding was a very special concept. But it is not without reason that he said that those who understand compounding deserve it, and those who do not understand it pay. Compounding can therefore be very expensive for someone who acts without knowledge.
Compounding can also entail risks. It is therefore very important to determine in advance for yourself how much risk you are willing to take. Based on your risk appetite, you can see which investment product suits you best. In addition, it is also true that compounding requires a long-term vision, so it is not useful to invest with money that you may need in the short term. It is therefore highly recommended to first map out your current situation before you start.
*On the basis of this article, we do not encourage anyone to start investing. This article is not written for advisory purposes and is not intended as any form of expert (financial, tax or legal) advice. This article is purely for conveying knowledge and information. Thriven is therefore not liable for the correctness or completeness of the articles.
**Starting with compounding? This article is not written for advice, nor does it encourage compounding. Every investor can benefit from this, but there are also risks associated with this. If you do want to start with it, it is important to maintain healthy expectations, gain enough knowledge and adopt a long-term vision.
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