Compounding interest and investment returns
In traditional savings vehicles interest returns are compounded over time when they are reinvested. For an investor there are two sources from which compounding can take effect - capital returns and dividends (when reinvested).
Compound interest
For long-term savers, compound interest comes into effect when money is placed in a savings account or money market instrument where interest is the return received. For compounding to take full effect, all interest returns should be left in the savings account to accumulate over a long period. Interest will be earned on the interest already earned as the capital base becomes bigger. By withdrawing the interest, the potential capital base is reduced, meaning less interest for the saver over time.
Compound returns
Source: moneyworksforme.com
Compound returns relate to investing and investment returns. Unlike interest, investment returns can be volatile (move up and down). There is a higher element of risk when investing on the market; however, with that risk comes greater potential returns.
Like an interest instrument, an investor receives returns, but from two sources - dividends (the company shares profits) and capital returns (share price increases).
- Dividends represent a portion of a company's profits paid to shareholders. A dividend yield is the dividend received divided by the share price. If a stock has a price of R100.00 and pays a R5.00 dividend the company would have a 5% dividend yield. For compounding to take effect, that dividend of R5.00 must then be reinvested back into your share portfolio, either to buy more of the same share or another share.
- Capital returns represent the increase in a company's share price. If an investor bought a share at R100 and the share price were to increase to R110.00, the return on the share from a capital point of view would be R10.00 or 10%. Selling the stock and removing the R10.00 from your portfolio would eliminate the compounding effect on the R10.00 returns. To take advantage of compounding an investor would either hold on to the stock, or sell the stock at R110.00, realising a R10.00 gain in the portfolio, but then reinvest the full R110 back into another investment.
Both actions will have the impact of widening the investor's capital base on which he or she can enjoy higher dividends and capital growth.
The bottom line
Compounding - whether in savings or investment vehicles - is a proven strategy to achieve long-term goals faster. Make sure you are allowing your wealth to compound over the long term by staying the course and remaining committed to your investment strategy.
