The power of compounding

So, what is the compounding effect and why is it so important?

Basically, what compounding is in financial terms is that you earn interest on the interest you earn which accelerates and over time results in exponential gains. Compounding is important in achieving wealth through passive means over time with little to no effort in maintaining the positions.

What are some key ingredients to worry about?

The number 1 key ingredient is the rate of returns and how stable that rate is. For example, in a regular savings account with a bank, that rate is generally stable in that it changes very slightly YoY while in stocks, the rate may change with fluctuations in the markets. The number 2 ingredient is the tax rate that will be charged to your interest rates. If possible, try to tax shelter the earnings with a registered account in your country, (Canada: TFSA, RRSP, etc) (USA: Roth IRA, etc). The 3rd ingredient is the amount of time the compounding is allowed to take. The longer the time, the more growth one will see in their account. Finally, the most important ingredient is deciding whether to make additional contributions such as monthly contributions or bi-weekly contributions. A consistent contribution plan to your account will dramatically increase the rate of returns.

So, what does this look like?

If an individual invests $10,000 and earns a rate of return at 10%/ year and does not contribute any additional funds:

With additional funding for example a monthly contribution, this growth is even more greatly accelerated. The key ingredient other than monetary is patience. The compounding effect takes time to occur much like a snowball rolling down a hill but at a certain point, the growth becomes exponential, and the value will explode.

Our opinions on the application of compounding for your finances.

We feel that the best approach to compounding is through dividend investing rather than through a HISA (high-interest savings account) as interest rates at major banks and across the financial sector are extremely low. When calculating the rate of returns, one can look at the historical returns of a certain stock to know the stock appreciation. Additionally, if the stock picked was a dividend-earning stock, one should look for the percentage dividend. Ultimately, for beginners, we suggest a market tracking ETF (SPY, QQQ, etc)for the best rate of returns as historically, index-tracking ETFs have outperformed actively managed accounts with individual stock picks.