The power of compounding in investing

Time could help regular-savings-plan investors chalk up a con­sid­er­able sum of returns.

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Clearly, the ini­tial invest­ment sum plays an impor­tant role in the sum of returns. Let’s say you invest $100,000, assum­ing an invest­ment return of 20%, you would get $120,000 in total. The sum would dimin­ish to $12,000 if you had invested only $10,000 at the same rate of return. So some peo­ple may have an illu­sion that invest­ment only work well for peo­ple who invest large sums of money.

Well, not exactly. Even if you invest a rel­a­tively smaller amount, you could make a very good return by util­is­ing the power of com­pound­ing. What you need to have on your side is TIME; or sim­ply to invest early. Let’s illus­trate how much $100,000 would grow at steady rates of return over dif­fer­ent peri­ods as shown in Table 1.

Assum­ing a long term rate of 2% per annum, the ini­tial amount of $100,000 would grow to $ 122,000 in 10 years, and $181,000 in 30 years’ time. How­ever, if you chose to just invest into fixed deposits at this point of time, you would prob­a­bly expect a lower rate to be used for com­pound­ing. The cur­rent fixed deposit rates from three largest local bank ranges from 1.4% to 1.5% per annum as at 20 Feb­ru­ary 2008. If you chose to invest in a diver­si­fied bal­anced port­fo­lio with a 40% weight­ing in fixed income funds and 60% weight­ing in global equity funds, you would prob­a­bly expect returns from 5% to 7% per annum over the longer term.

Thus, if an investor chose to invest in a diver­si­fied port­fo­lio with an aver­age rate of return of 7%, the invest­ment could grow at a faster pace. Assum­ing a rate of return of 7%, in 10 years, the invest­ment will grow to $197,000 and to $761,100 in 30 years’ time.

You may won­der, “What if I am good at build­ing an aggres­sive equity port­fo­lio and I invest early?” Assum­ing an annu­alised return of 12% — in 10-year’s time you would have made $311,000, which is 3.1 times of the orig­i­nal invest­ment amount. The sum bal­loons to almost 30 times the orig­i­nal amount in the span of 30 years. A great value investor like War­ren Buf­fet gen­er­ated annu­alised returns of 21.4% in the past 42 years (since 1966). With the power of com­pound­ing, the invest­ment grew tremen­dously to 336 times the orig­i­nal amount in 30 years.

Table 1: Invest­ment returns of $100,000 at dif­fer­ent annu­alised rates

The table above illus­trates that fixed deposit may look safe but would entail sub­stan­tial “oppor­tu­nity cost” of giv­ing up invest­ment. As long as you invest early and pick the right asset class or port­fo­lio, even a decent annu­alised return of 7% would bring you a long way. Invest­ing for the long term also helps investors to tide over short-term volatil­ity in equity mar­kets. Long-term value investors are less-likely to exhibit too much fear dur­ing volatile times unlike many ordi­nary stock investors who just look into momen­tum investing.

Other than invest­ing a lump sum for the long term, investors may also choose to invest reg­u­larly by using the Reg­u­lar Sav­ings Plan. This invest­ment strat­egy is suit­able for long-term investors to make use of the power of compounding.

Kelvin Yip (Assis­tant Research Man­ager & Finan­cial Adviser Rep­re­sen­ta­tive) is part of the Research and Edi­to­r­ial team at Fundsupermart.com, a divi­sion of iFAST Finan­cial Pte Ltd.