Compounding In Investing: What Is It And How It Works For You

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Investing is one of the most powerful things you can do to build wealth for the long-term. Simply put, it’s your money making more money over time, through a concept known as compounding.

Here’s what we mean. Suppose you invest $100,000 today. 20 years later, your original investment would have more than tripled to $386,968, assuming it earns 7% every year. 

Note: Assumes a 7% rate of return, compounded annually

Your money grew through the effect of compounding, earning returns on top of returns already earned. Assuming you left your investment untouched, your portfolio gains would be reinvested, thus allowing returns to grow on both your principal and reinvested gains.

But if you were to take out the gains on your investment each year without reinvesting it, you’ll only earn $7,000 every year for a total of $140,000 over 20 years. Compare this to the $286,968 more you could have earned if you had let compounding do its magic instead. 

How to make compounding work for you

To reap the benefits of compounding, remember that time is your best friend. The earlier you start investing, the more your money has the potential to grow. 

Let’s look at two friends, Jack and Jill. Jack starts investing at age 25. He invests $20,000 every year for a total of 10 years. Thereafter, he stops contributing to his investment portfolio and leaves his money invested for the next 30 years.

Jill starts investing later than Jack. She begins at age 35 and invests $20,000 every year for 30 years. As the graph below shows, Jack ends up with more money than Jill. This is despite the fact that Jill’s total invested amount is $400,000 more than Jack’s.

Note: Assumes a 7% rate of return, compounded annually

Don’t underestimate the power of starting early, even if you can’t contribute a lot just yet. That’s because compounding allows your investment returns to earn more returns on itself. So in the long run, a small amount of money invested earlier will end up being more than a large amount of money invested later.

The power of regular investing

A common misconception is that you need to have a lot of money to start investing. But that’s not true. Even with a small investment each month, you’re still accumulating wealth over time due to the power of compounding returns. 

This habit of regular investing is also known as dollar cost averaging (DCA). There are several advantages to this strategy. First, DCA can help you cushion the impact of market fluctuations. By consistently investing a fixed sum of money over a period of time, you end up buying more shares when prices are low and fewer shares when prices are high. Over the long term, the cost of your investments are averaged out.

DCA’s other benefit is psychological. Because you’re investing consistently regardless of market conditions, your emotions are removed from the equation. For example, most people prefer avoiding losses more than they like winning – a behavior formally known as loss aversion. When the market plummets, some investors may panic and sell at the market bottom. If you’re dollar cost averaging, you’ll instead be purchasing your investments at an attractively low price. 

Over the long term, markets tend to go up. DCA helps you recognise that market downturns can be an opportunity, not a threat. When the market drops, you’ll be able to buy more shares with the same investment amount. 

Let your earnings be reinvested

It can be tempting to take your dividends out of your portfolio and spend them every year. But reinvesting your dividends is a much smarter way to boost your compound returns. By buying more shares using your dividends, you grow your investment base. Remember, when your investment amount is higher, your compounded returns are higher too. And over time, it can seriously add up. 

That’s why Syfe helps you reinvest your dividends. The process is simple and automatic. You transfer money to your Syfe portfolio, we invest it for you. Dividends you receive will be credited to your portfolio and then reinvested, at no extra charge.

Investing is truly one of the ways anyone can use to build wealth. Getting the most of it is simple: invest early, be patient, and reinvest. The best part? Getting started is just as easy with roboadvisors like Syfe making investing in Singapore possible in just 3 minutes.

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