Even investing small amounts on a regular basis will compound returns over time.
Among many other things, the theoretical physicist and Nobel Prize winner Albert Einstein had a strong grasp of mathematics, particularly around the power of compounding interest returns.
“Compound interest is the eighth wonder of the world,” said Einstein. “He who understands it, earns it. He who doesn’t, pays it.”
They were wise words, and they equally apply to any investments that receive income returns and allow additional amounts of money to be added on an ongoing basis.
Leveraging the power of compounding is actually at the heart of investing. Put basically, it’s about growing a smaller amount of money into a bigger amount through a process of continual adding over time.
Typically, the more that’s added, and the more frequently it’s added, the larger the growth over the long term.
Your superannuation at work
An easy way to think about compounding is your superannuation. As your employer makes regular contributions into your account, your savings balance will continue to rise over the long term. That’s due to the money being added in from your employer, but it’ also because of the investment returns that you’re earning on your growing super balance.
Making additional personal contributions on top of your employer’s contributions can have an even greater impact on the size of your retirement savings balance over time.
And the same applies to investments outside of super. An initial starting amount of money is likely to compound over time if regular ongoing investments are made that also harness the growth returns from the underlying investments.
Just like your super contributions, investing outside of super should ideally be aligned to a disciplined, non-emotional, approach that’s not affected by what’s happening on financial markets at any point in time.
Compounding case studies
This may all sound very theoretical, so let’s look at some real examples of compounding growth based on the actual returns from two Vanguard managed index funds over the last 10 years.
We’ve used the returns from the Vanguard Australian Shares Index Fund (which invests in the top 300 companies on the Australian Securities Exchange) and the Vanguard International Shares Index Fund (which invests in around 1,500 companies across 23 developed markets, excluding Australia).
The final results, as at 30 June 2024, are based on an investor having made a $5,000 starting investment into each fund on 1 July, 2014.
The returns compare someone who didn’t make any additional investments over the 10-year period to people who added either $100 per month, $200 per month, or $500 per month.
All of the end returns assume that each investor chose to reinvest all of the income payments that they received on their investments over the 10 years. That is, rather than taking them as cash payments, they used them to purchase additional units in the same fund.
This is a key aspect of compounding, because following a reinvestment strategy means that the number of fund units owned by investors will continue to multiply over time. Any income payments received will be based on a higher number of owned units.
Vanguard Australian Shares Index Fund
| $5,000 investment on 1 July 2014 | No additional investments | Investing $100 per month | Investing $200 per month | Investing $500 per month |
|---|---|---|---|---|
| Balance at 30 June 2024 | $10,720.52 | $29,195.82 | $47,671.12 | $103,097.01 |
Source: Vanguard. Investment balances exclude acquisition costs, fees or taxes. The example is illustrative only and is based on the factors stated. Past performance is not a reliable indication of future performance.
The numbers in the table illustrate the power of compounding through a combination of long-term growth, reinvesting income, and making regular ongoing investments.
By making no additional investments on top of the initial starting balance of $5,000 on 1 July 2014, an investor in the Vanguard Australian Shares Index Fund would have more than doubled their investment by 30 June 2024 if they had reinvested all their income payments into buying additional fund units.
Yet, by making additional investments at regular monthly intervals and reinvesting all income received, an investment would have compounded even more.
Investing an extra $100 per month, and reinvesting all income, would have lifted an investor’s balance to $29,195.82 by 30 June 2024. Subtract from, that the $12,000 of extra investments made over the period and an investor would still have gained more than $17,000 as a result of compound growth.
Following the same investing strategy, an investor who invested $200 per month would have more than trebled their initial investment amount. Even after subtracting their $24,000 in regular investments an investor would have gained more than $23,000 over the term.
Someone investing $500 per month, and following the same strategy, would have ended up with more than $100,000 over 10 years. That equates to a total gain of 1,962%.
Of course, to get to that level, they would have needed to invest $60,000 over the period. But that’s still a gain of more than $43,000.
Here’s what the numbers look like for the Vanguard International Shares Index Fund.
Vanguard International Shares Index Fund
| $5,000 investment on 1 July 2014 | No additional investments | Investing $100 per month | Investing $200 per month | Investing $500 per month |
|---|---|---|---|---|
| Balance at 30 June 2024 | $17,301.28 | $40,818.51 | $64,335.75 | $134,887.46 |
Source: Vanguard. Investment balances exclude acquisition costs, fees or taxes. The example is illustrative only and is based on the factors stated. Past performance is not a reliable indication of future performance.
While the numbers in the international fund are substantially higher, reflecting the stronger average returns on overseas share markets over the last decade, they similarly illustrate the power of compounding growth.
A $5,000 starting investment in this fund with no additional investments, apart from reinvesting income payments, would have more than trebled. And the final balance numbers at 30 June 2024 would have been much higher, based on the size of additional monthly investments.
Of course, lower or higher amounts of regular investments over time would have produced the same outcome. That is, they would have continued to compound.
Sticking to a plan
Investment markets, particularly equities markets, can be volatile at times. When share markets fall, the value of most share investments also fall. As such, shares tend to be regarded as higher risk than investments that are not subject to rapid daily price movements, and are better suited to investors who have a higher risk/return profile.
Yet, it’s also fair to say that the long-term upward trend on global share markets has regularly produced higher investment returns over identical time periods than lower-risk assets such as bonds and cash.
Just like with your super contributions, investing outside of super should ideally be aligned to a disciplined, non-emotional, approach that’s not affected by what’s happening on financial markets at any point in time.
Making regular investments, and reinvesting income, can really add up over time.
They’re a powerful combination in helping you to focus on achieving your investment goals, ideally through an appropriately diversified portfolio, to give you the best chance of investment success over the long term.
Our investment team is ready to help you accomplish your financial goals and needs. Feel free to send us an email at info@centrawealth.com.au or give us a call at 08 82314709.
Article courtesy of Vanguard.
