The Power of Reinvesting   Reinvesting earnings is a powerful tool that can help investors grow their wealth, thanks to a phenomenon called compounding. Warren Buffett once said: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”  What is compounding, and why is it so important to investors?  Well, we’re going to dig into that here.

What Is Compounding?

The simplest way of explaining compounding is that you are making returns on top of your returns.  I’ll use a simple example to help clarify:  say you make a $10,000 investment into a bond that pays 8% interest, semi-annually, meaning you receive a $400 payment twice a year.  Now, if you just took the two $400 payments, and assuming you don’t care about price changes in the bond, your return is 8% per year.   Pretty self-explanatory, right?  Well, what happens if you reinvest your first interest payment as soon as you receive it?  Your investing base (the amount upon which you earn interest) rises from $10,000 to $10,400 for half the year.  Now, if we multiply that by 4% (our 8% interest divided by 2 to account for the semi-annual payment), you now earn $416 on your second interest payment.

The Power of Compounding

That extra $16 may not seem like all that much, but here’s the difference that reinvesting can make over time: if you were to simply take the interest payments you received, it would take you 25 payments to double your money, or 12.5 years. If you reinvest your earnings, it would only take you 9 years instead.  If you had been reinvesting for the same amount of time it took to double your money without reinvesting, you’d have made an extra $6,700!

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For investors with a long-term investment horizon, those three extra years can add up.  With an investment horizon of 30 years, you’d make about 9.5 times your initial investment ($95,196.27 in profit), whereas if you just took the interest out, you’d receive less than 2.5 times what you initially invested ($24,000).

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Compounding With Stocks

From an stocks perspective, the S&P 500 returned roughly 79% over the past 10 years.  If we had reinvested dividends, that changes to 123%, and goes from a 6.01% annualized return up to an 8.3% annual return!  (Calculated from 11/20/2007-11/20/2017, Source)

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Compounding is an incredible tool in an investor’s arsenal for growing their wealth.  It’s not just useful to purely income generating investments, but to investments that have occasional cash flows as well.  The growth power compounding can provide is why AlphaFlow offers its investors the ability to have not just their repaid principal, but earnings reinvested as well.    

We’ve included a calculator that you can use to see the power of compound interest!

Disclosure: All data presented here is for demonstration purposes only. Past performance is not indicative of future returns. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Investors should consult with their own legal, financial, and tax advisors. While AlphaFlow strives to make the information in the article as timely and accurate as possible, AlphaFlow makes no claims, promises, or guarantees about the accuracy, completeness, or adequacy of the contents of this article, and expressly disclaims liability for errors and omissions in the contents of this article.
 

About the author:

Nick GiovacchiniNick Giovacchini is the Client Services Director at AlphaFlow. Prior to joining AlphaFlow, Nick worked for Barclays Risk Analytics and Index Solutions team, working with institutional asset managers to analyze risk and performance drivers of their portfolios. He also was an Account Manager for MarketFactory, a leading technology provider for the FX world.

Nick has a BA in Political Science from George Washington University in Washington, DC.

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