Posted on January 20, 2009 - by Createwealth8888

The power of compounding in investing

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

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.

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

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. Read more…

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