Have you ever been encouraged to start investing—as soon as possible? Whether by a friend, mentor, or stranger, whoever suggested it probably also mentioned a magical force called compound returns.
The sooner you get started, the better, they might say. Even getting started with small amounts can make a big difference, when you are young or have a long investing time horizon.
How does one activate these special powers? By waving a wand and sprinkling fairy dust across an investment portfolio?
Compound returns, also known as compound interest, can be achieved by investing in asset classes that earn interest on both the initial amount you invested and all previous profits. Essentially, you are earning money on top of the money that you already earned. No secret potions or spells needed.
When you are earning compound returns, you’re really putting your money to work.
How can investors receive compounding returns? Here’s a closer look at the investing and mathematical phenomenon and how to achieve it. With a few simple steps, anyone can work toward compound returns.
The Value of Compounding Returns
If the idea of compound returns makes your head spin, it’s okay. It’s a lot easier to understand by looking at an example:
An investor buys a stock that costs $1,000. That’s the investment’s “principal.” In the first year, say they earn a 10% return. The stock is now worth $1,100. Pretty straightforward, huh? Things start to get interesting in the second year, when the stock increases in value another 10%, bringing the stock’s value to $1,210.
That’s $110 in profit earned in the second year, compared to $100 in the first year. This happened even though they did not add any of their own money to the investment, and they earned the same rate of return. The investment had simply grown over the previous year, creating a larger base from which to earn more.
If the investor were to earn a 10% rate of return the third year, the profit would be even greater than in the previous two years. Working off a larger base—now $1,210—a 10% return will yield a profit of $121. The rate of growth is not only increasing, but it’s doing so at an increasing rate.
Estimating Compounding Returns
A great way to become comfortable with the concept is to play around with a compound return calculator. When looked at on a graph, you’ll see the rate of growth increase and the graph start to shift vertically. That’s when compound returns start to get exciting.
You’ll notice, though, that this does not happen right away. It depends on the rate of return, but the most powerful effects could take decades. This is why people are often encouraged to start investing as young as possible, even with small amounts. The longer that money is invested, the more compounding it can do.
Compound returns can be compared to a cartoon snowball that’s rolling downhill. When a snowball is small and rolling very slowly, it doesn’t amass much more snow. But when it starts to get bigger and rolls faster and farther, it can amass much more snow. In this example, the snow being amassed by the snowball is the profit.
An investor might have just a small snowball now, but this is a long game. Maximizing time can allow the proverbial snowball to grow bigger, roll faster, and amass much more in profits through the years.
How to Receive Compound Interest
Okay, you now understand the freaky-deaky magic of compound returns. But how can you actually earn them?
Compound returns can be earned either via an investment that increases in value over time or through the reinvestment of interest. The reinvestment of interest may be done automatically or manually.
For reference, compare compound returns, or compound interest, to simple interest. With simple interest, the investor is paid a rate of return on an agreed-upon schedule. A bond is an example of this. Generally, bonds make interest payments twice annually, and those payments are deposited into the account where the bond is held.
Because interest on a bond payment is made in cash and is not necessarily added to the value of the bond, the investor does not automatically earn compound interest. Without action, the money may just sit in the account, uninvested. The money would have to be manually reinvested for the effects of compounding to be activated.
Here are some examples of investment types that can automatically earn compound returns.
Stocks: There are two ways to make money on a stock. The first is through price appreciation, and the second is through dividend payments. When the value of a stock grows over time, an investor earns compound returns. With dividend payments, compound returns are not automatic, as they are paid out in cash.
Mutual funds: Mutual funds are pools of stocks, bonds, or other investment types. For example, a mutual fund could invest in the U.S. stock market. Over time, the goal is that the mutual fund grows as the underlying investments grow. Many mutual funds give the option of automatic dividend reinvestment. This way, the investor can earn compound returns in both ways, on the price appreciation and the dividend payments.
Exchange-traded funds: Similar to mutual funds, ETFs are pools of investments, like stocks. As the value of the ETF grows over time, returns will compound. Depending on which bank or institution where the ETF is purchased, it may or may not be possible to automatically reinvest dividends.
Yield-generating savings accounts: Some savings accounts pay interest on cash balances, such as an online-only savings bank, a savings platform like SoFi Money®, and some savings accounts at credit unions. It is possible to earn interest on top of interest earned in previous months, therefore earning compounding returns.
With all investments, returns are not guaranteed. Investments that earn a higher potential return may also come with higher risk. Investments in the stock market, including mutual funds and ETFs that hold stocks, may experience volatility. Take the example from above. Three consecutive years of precise 10% returns is unlikely. While helpful for understanding the concept of compound returns, it’s not reflective of the real-world experience.
Getting In on the Action
The first step to earning compound returns is to open an account to invest in. Whether a Roth IRA, a brokerage account, or an account on an online trading platform, these are simply accounts. Once money is deposited in the account, it can be used to buy investments such as stocks, mutual funds, and ETFs.
There are lots of options. You can consider opening an account at a brokerage bank or on an online trading platform like SoFi Invest®. Keeping fees as low as possible is important for new investors so that more of their money is working and earning compound returns. SoFi Invest® makes this possible with free trades and accounts.
Once the account has been funded, investors can make their choices. Someone who prefers to research and pick out investments might be interested in SoFi® active investing. For a guided approach to investing and an automated and diversified investment approach, check out automated investing.
Interested in a stock but can’t swing the price? Ponder a nibble, a fraction, of select stocks and ETFs with Stock Bits.
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