March 30, 2018

The Power of Compounding

Albert Einstein once (allegedly) called compounding interest the most powerful force in the universe. While claims that the famous scientist uttered these words are dubious at best, what is not in question is that compounding interest is an incredibly powerful tool that all investors can leverage.

The idea of compounding interest is straightforward – it pays to earn interest on your interest. What is a bit harder for most of us to conceptualize is the cumulative impact of compounding interest over time. It is even more difficult to conceptualize the impact of earning (and compounding) a percentage or two “more” over a long time period, and how much of a difference it can make in long-term outcomes. This blog post will provide readers with some context for each of these calculations.

The more you invest, the more your money can compound.

If you invest $1,000,000 in an account that earns 5% and withdraw your earnings as soon as interest is paid, you would receive $50,000 in earnings from the account each year, adding up to $500,000 in earnings over ten years. But if you left the assets in the account rather than withdrawing them, at the end of ten years, you would have $1,629,000 – more than $100,000 in additional earnings due to the power of compounding interest!

At Arnerich Massena, we pride ourselves in outperforming the market over complete market cycles by building diversified portfolios – including both publicly traded and privately held investments – that outperform the overall marketplace while minimizing volatility. When we are successful in our mission, the added investment performance really adds up. Each percentage point of outperformance can make a huge difference over time, thanks to the “magic” of compounding.

The impact of outperformance

In this chart, you can see the difference in a $1 million investment over ten years if it earns a 5% return (as in the above example), a 6% return, or a 7% return.

What a difference a single percent difference in return makes! The important point to note is that the hypothetical “ending values” in this illustration do not increase in a linear fashion as the rate of return increases – because compound interest is magnifying the impact of that added rate of return each year.

This sort of computation gets my fellow Certified Financial Planners excited (we love our future value calculators), and it is critically important that investors understand the concept as they navigate the options available to them. If you’d like to talk about how compounding interest may affect your long-term plans, or if you’d like to discuss how our team builds portfolios designed to outperform the market over complete market cycles, you can contact us here.