The Wonders of Compound Return

Key Points

• The “power of compounding returns” is a phrase that has been used by many investors and especially the big man himself, Warren Buffet. But what does it mean?
• Effectively compounding returns means that whatever percentage return that you are earning will increase in terms of actual money over the life of your investment.
• In the most simple form, say a $100 investment gains 10% this year, we now have $110 dollars. If we get the same percentage return next year (10%) now we will have $121 dollars. This is why compound returns are so powerful.
• This additional dollar comes from the larger base of initial investment and speaks to why it is key to get invested when possible and to stay invested.

How does Compound Return play into My Investments over the Long-Term?

Investors consider compound return to be a more accurate gauge of an investment’s return over several years because of how volatility plays as a factor. This will often be expressed as the Compound Annual Growth Rate (CAGR) and below is an example of how this will work using the S&P 500.

• The S&P 500 has an average annual return of 8%(CAGR). The truth is the S&P might return 28% one year and then -2% the following fiscal year. Since inception, the math on the average annual return has come to be about 8% adjusted for inflation.
• A young investor has chosen to make a $5,000 investment into a S&P 500 Index Fund.
• The average annual return remains at 8% with market volatility over five years.

Math

• Year 1: $5,000 x 8%= $5,400
• Year 2: $5,400 x 8%= $5,832
• Year 3: $5,832 x 8%= $6,298.56
• Year 4: $6,298 x 8%= $6,802.44
• Year 5: $6,802 x 8%= $7,346.64

Conclusion

And so and so on..well you get the point. As long as the world keeps spinning and businesses keep rolling forward with innovative products and services, you will be glad you decided to invest in the Mighty S&P and let your investment compound overtime.