If you had of asked Albert Einstein what the most powerful force in the universe was, what do you think he would say? Gravity? The strong nuclear force? The answer is none of these. Albert Einstein quoted that “compound interest is the most powerful force in the universe.” Einstein was being metaphorical of course but why would Time Magazine’s person of the 20^{th} century say such a thing? This question is best answered with an example. If you or a relative had of invested $1,000 in the top 500 companies on the ASX in 1979 and reinvested all dividends, your investment would be worth $46,000 today. How does this work? The ability for your investment to grow so superbly is due to compounding returns. Take interest earned on a savings account for example. If the interest earned is reinvested back into the account then subsequent interest payments are not only paid on the original investment but also on the reinvested interest. This is exemplified in the following table. You can see that the case on the left for compounding interest has earned more interest than the case on the right where the interest is not reinvested.
Compounding Interest | Simple Interest | |||
Year | Investment Balance | Interest Earned | Investment Balance | Interest Earned |
0 | $10,000 | $500 | $10,000 | $500 |
1 | $10,500 | $525 | $10,000 | $500 |
2 | $11,025 | $551 | $10,000 | $500 |
3 | $11,576 | $579 | $10,000 | $500 |
Total Interest | $2,155 | Total Interest | $2,000 |
An additional $155 may not seem like much, but let’s see what happens if we extend this investment over a longer period of time. As the figure below shows, the longer that the investment is left to compound then the more rapidly it starts to grow.
Compounding Applied to Shares
Thus far, I have been explaining compounding returns in the context of interest bearing investments. But what about shares. Instead of interest, shares pay out their profits to the shareholders in what is called a dividend. This dividend can be reinvested by using it to buy more shares. Each additional share earns additional dividends, thus, compounding can also be achieved by share investments. The figure below shows the annual value of the All Ordinaries Index. The compounding nature of the growth in the $10,000 investment can be seen to resemble an equivalent compounding interest of 12% per annum. That’s right, 12%. The fluctuation in value is caused by alternative factors that affect the share price.
Time in the Market is more important than Timing the Market
There is a famous quote for investing that says, “Time in the market is more important than timing the market.” Some people will hesitate from investing until the next low point in the share price. But when will that occur? No one knows. It is impossible to tell whether the share price next week will be lower or higher than it currently is. In waiting for the perfect entry point investors may forgo the opportunity to receive dividends and start their compounding journey. Furthermore, if you regularly invest indiscriminate of the share price, your portfolio benefits from dollar cost averaging. Therefore, rather than trying to time the highs and lows it is better to invest as early as possible to expose your savings to the greatest amount of time in the share market.