The more time your money has to grow, the more you can benefit from the power of compounding.
Many people look at investment returns as simply their fixed income and/or equity holdings going up and down in value. They may also like the idea of their investments paying them regular interest income or dividends.
Instead of being paid that interest income or those dividends, however, both these income streams can be used to achieve stronger long-term growth through the power of compounding.
Sounds good, but what is “compounding”?
Compounding is simply the reinvestment of any interest income and dividends paid by your holdings. In the case of many mutual funds, payments can be taken in cash or reinvested automatically into additional units of your chosen investments. Although taking regular distributions in cash can be a good way to pay for your current financial needs, reinvesting these payments back into your mutual fund holdings means more of your money grows over time – because you’ll be earning money on the amounts you’re reinvesting.
Let’s consider an example:
You invest $1,000 in a mutual fund priced at $10 per unit, so you buy 100 units. If the fund pays a distribution of $1 per unit, you receive $100. Assuming the fund remains at $10 per unit, you can reinvest your distribution in the fund and receive 10 more units, for a new total of 110 units. Next year, the fund pays another distribution of $1 per unit, but now you will receive $110 because the distribution is also paid on the 10 additional units you had previously reinvested in the fund. With each subsequent distribution, your money will grow faster and faster as any income you reinvest in the fund will earn income of its own. (Note that this example does not take into account any changes in share or unit value or any sales, redemption, distribution or optional charges or income taxes payable by the investor.)
That’s the power of compounding. Reinvesting your payments this way has been shown to be an effective strategy for growing your savings over longer periods of time. And the earlier you start, the more time your money has to grow.
Starting earlier can mean bigger amounts later on
It may not seem like much now, but starting to invest 10 years earlier can have a dramatic impact on your long-term returns.
Let’s look at the investments of two investors within the S&P/TSX Composite Total Return Index:
Investor A began investing $2,000 each year on January 1, 1995. After 10 years, Investor A stopped contributing, but allowed the investment to grow for the next 10 years.
Investor B waited for 10 years and, at the end of December 2004, began investing $4,000 each year for 10 years.
By starting early and taking advantage of compounding returns, Investor A accumulated $4,667 more than Investor B, even though $20,000 less was invested.
Source: Morningstar Direct. Data from January 1, 1994 to December 31, 2015. The information provided is for illustrative purposes only and is not meant to provide investment advice. You cannot invest directly in an index.
An effective strategy to use when compounding
One of the best ways to benefit from the power of compounding is to use it within your registered accounts. By reinvesting your interest income and dividends within your registered retirement savings plan, tax-free savings account, registered retirement income fund, or another registered plan, you benefit from the power of compounding – as well as the attractive tax-deferral benefit provided by your registered plan.
To learn more about the how to get started, contact your financial advisor or visit AGF.com.
The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.