Why is Compounding Important When it Comes to Investing?

I answered this question on Quora here

Let’s take an example of 100% daily returns in 2 different scenarios:

1. A penny that gets 100% return every day, but the returns are not re-invested, will result in 29 new pennies at the end of 30 days. The wealth grows from 1 penny to 30 pennies.
2. A penny that gets 100% return every day, and the returns are reinvested, will result in an ending wealth of $10,737,418.25

In the first example, the investment earns a simple interest of 100% daily. In the 2nd example, the investment earns a compound interest of 100% daily.

Granted the 100% daily return is an extreme example. However, a smaller rate of return over a longer period of time has a similar outsized result when compounded.

What does this mean for investors?

You can think of most investors as having 2 distinct phases in their investment career. Younger investors likely have other source of income, and they invest their discretionary income. As a result, they may not need this money to live on.

They are in the accumulation phase.

At or after retirement, investors would like to be able to withdraw the principal or the profits from their portfolios in order to live and enjoy their wealth. They are in the distribution phase.

The goal for most is to maximize their returns when they are in the accumulation phase. This can be done by keeping their capital invested as long as they can, and then reinvest every dividend and interest they receive.

This way they can maximize their wealth over time.

Later when they are in the distribution phase, they can enjoy the benefits of the compounding.

Maximizing your compounding

You can maximize your compounding and resulting wealth by the following levers:

1. Time: More time in the market means longer compounding period. This will help grow your wealth more
2. Returns: Higher returns, if reinvested, means faster compounding and greater resulting wealth
3. Frequency: More frequent compounding increases your wealth faster. A 5% annual dividend yield, when reinvested, is better if it is paid in quarterly installments, rather than an annual lumpsum payment

Finally, keep in mind the effects of taxes and other factors that can interfere with compounding and destroy your wealth generation potential. I talk about many of these in my article on compounding here.