At one point or another, we’ve all heard or read advice that strongly suggested we begin investing. Those conversations likely highlighted the magic of compound interest and stressed the importance of getting started as quickly as possible.
How do investors receive compounding returns? Here’s a closer look at the practice and steps on how to achieve it.
What Are Compounding Returns?
Compound returns, also known as compound interest, are the earnings you continuously receive from contributions you’ve already made to an investment.
Compound interest can be achieved by any type of asset class that earns interest or produces returns on both the initial amount–what’s known as the principal–as well as any profits or returns that are generated after the initial investment. Essentially, the money you put to work is doing additional work automatically for you.
How Does Compounding Interest Work?
A great way to become comfortable with the concept of compound interest is to play around with an online compound interest 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. Compound interest depends on the rate of return, essentially how much the investment gains or losses over time, 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 snowball that’s rolling downhill. At the beginning the snowball may be small and rolling slowly. But as the snowball starts to collect snow, it gets bigger.
Compound interest is a long game. Time can allow the proverbial snowball to grow bigger, roll faster, and amass more profits through the years.
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The Value of Compounding Returns
Here’s a hypothetical example that captures the idea of compound returns. However, it isn’t necessarily realistic, because it only speculates an investor making profits. In reality, an investor could also experience losses.
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. 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 additional 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.
However, investments that hold stocks may experience volatility. Take the example from above. Three consecutive years of precise 10% returns is highly unlikely. In fact, it’s also possible for investors to lose money on their investments, which is the case in almost any asset class. While helpful for understanding the concept of compound returns, it’s not necessarily reflective of the real-world experience.
How to Get Compound Interest
With compound interest, the reinvestment of interest may be done automatically or manually.
Here are some examples of investment types that can 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 sees the potential to earn compound interest if those profits are reinvested. With cash dividend payments, compound returns are not automatic, as they are paid out in cash but an investor can add the payouts back in in order to potentially earn additional returns.
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 plans. This way, the investor can earn compound returns in both ways, on the price appreciation and the dividend payments.
Exchange-traded funds (ETFs): 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.
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Yield-generating savings accounts: Some savings accounts pay interest on cash balances. With these accounts, it is possible to earn interest on top of interest earned in previous months, therefore earning compounding returns.
With all investments, a good return on investment is not guaranteed, even profits aren’t. Plus, investments that tend to earn a higher potential return may also come with higher risk.
The first step to earning compound interest is to open an account to invest in. Whether it’s a brokerage account or automated investing service, 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 an online investment 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 with incurring costs. SoFi Invest makes this possible with zero-commission trading.
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