For Investors General

How Can Investors Receive Compounding Returns

November 13, 2019 6 min read

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How Can Investors Receive Compounding Returns

A Fable

Once upon a time, an Inventor of great rapport came to the great hall of the King to present a gift. The King cherished wit above all and was known throughout the land as a lover of games. The Inventor, knowing this, had crafted a new game just for the King.

Revealing a beautiful hand-carved mahogany box with black and white squares lacquered onto one side, the Inventor presented to the King the first chessboard.

“A marvelous gift!” the King exclaimed. “Tell me, Inventor, how I can repay you? Jewels, a wife at court, an estate in the country, what do you desire?”

“I am a simple man, and so my request is simple. I only ask for a little rice,” the Inventor replied.

The King, knowing he had granaries full of rice, said, “Of course! How much rice would you like?”

The Inventor smiled. “I would like one grain of rice here.” He pointed at the first square of the chessboard, then shifted his finger to the second. “Then two grains of rice here. Then four grains of rice here on the third square. Then eight, and so on, doubling until you have placed rice on all 64 squares of the chessboard.”

The King agreed without another thought on the matter.

For those familiar with the fable, you may already know how it ends. By the end of the first row, the King owed the Inventor 128 grains of rice. By the end of the second row, the King owed 32,768 grains of rice, and by the third, over 8 million.

Less than halfway through the chessboard, the King owed over 1 billion grains of rice, and the Inventor had crippled an empire.

Depending on whether you are an optimist or a pessimist, the Inventor was then either appointed a Royal Advisor or was beheaded for his insolence.

Such is the power of compounding returns.

What Are Compounding Returns?

Compounding returns occur when an asset, or series of assets, offers interest that compounds over time. Let’s unpack that. 

An individual owns an asset that earns interest over a specific time period. That period is called the compounding frequency, and it could be a daily, monthly, biannual or annual period, depending on the asset. Where compounding comes into play is that the interest earned in each period is not based on the original value of the asset: it’s based on that original value plus any interest earned in previous periods.

Here’s how that looks mathematically:

You have $1,000 in a savings account with an annual interest rate of 3% (in reality, most compound interest rates on savings accounts are just above 0% – but we’ll use 3% for the sake of example). That means each year, you’re entitled to an interest payment of 3% of the principle ($1,000) plus all interest accrued over time (for as long as you hold the assets,).

In year 1, you earn $30.00 (3% of $1,000), giving you a total balance of $1,030.00

In year 2, you earn $30.90 (3% of $1,030), giving you a total balance of $1,060.90

This $0.90 increase in interest payments may not seem like a lot, but over time, the increases accelerate more and more rapidly:

YearBeginning BalanceInterestEnding Balance
1$1,000.00$30.00$1,030.00
2$1,030.00$30.90$1,060.90
3$1,060.90$31.83$1,092.73
4$1,092.73$32.78$1,125.51
5$1,125.51$33.77$1,159.27
6$1,159.27$34.78$1,194.05
7$1,194.05$35.82$1,229.87
8$1,229.87$36.90$1,266.77
9$1,266.77$38.00$1,304.77
10$1,304.77$39.14$1,343.92

By the end of year 10, without you having to do anything, your interest payments have increased by 30% over the first year, while your account has increased in value by almost 35%,  simply by earning compound interest!

Compounding Interest vs. Simple Interest

The alternative to compounding interest is simple interest, which means the interest earned on assets does not include any prior interest payments. In the example above, your investment account would simply pay you $30 a year as long as you kept the balance at $1,000.

Because you earn interest on interest, compounding interest is often a more attractive alternative than simple interest.

How Can You Earn Compounding Returns?

Banks sometimes offer compounding interest to encourage people to open new accounts. These compounding returns are safe, steady, and passive. But remember – unlike our simplified example, most accounts offer extremely low compound interest rates!

So, for investors to reap truly impressive bounty from their investments, they need to be willing to take some risk and actively invest their money, rather than let it sit in an account slowly accruing interest. That means relying on their own savvy (or that of their advisors) and paying constant attention to their portfolios to increase the value of their holdings.

By investing in the stock market, investors can earn capital gains (the increase in value from the asset’s purchase price) that compare to compounding returns. Indeed, annual compound returns (or compound annual growth rate—CAGR, for short) is viewed as a more accurate way of gauging investment performance than simply looking at average returns as it takes into account the volatility of the asset price over time.

To put this into context with an example of success, an investor who bought Amazon stock at the moment of its IPO in May 1997 would have seen a compound annual growth rate of 38% if they still held the stock today.

But let’s say you aren’t investing in the next Amazon, and your investment strategy delivers you returns closer to the average.

If, for instance, you were to match the average annual return of the S&P 500, which is 8%, every year, and are willing to take the risk, you’ll still earn much greater returns than the passive interest rate:

YearBeginning BalanceCapital GainsEnding Balance
1$1,000.00$80.00$1,080.00
2$1,080.00$86.40$1,166.40
3$1,166.40$93.31$1,259.71
4$1,259.71$100.78$1,360.49
5$1,360.49$108.84$1,469.33
6$1,469.33$117.55$1,586.87
7$1,586.87$126.95$1,713.82
8$1,713.82$137.11$1,850.93
9$1,850.93$148.07$1,999.00
10$1,999.00$159.92$2,158.92

After ten years, the account has more than doubled in value!

While going after your own compounding returns allows for potentially greater gains, there is always risk involved in investing and returns are not guaranteed. For every Amazon that revolutionizes ecommerce, there is a Theranos that fails to revolutionize healthcare.

Similarly, earlier-stage investments, like early-stage startups, can deliver extremely high returns, creating an opportunity for investors to generate outstanding compound returns, or they can fail altogether. For example, a $200,000 angel investment into Uber would have been worth $3.3B today, with a compound annual growth rate of 194%. On the other hand, a $200,000 angel investment into Theranos would be worth $0 today.

The vast majority of startups fail. Generally speaking, greater returns require greater risk.

Conclusion

Compounding returns offer investors a chance to more quickly increase the value of their holdings. But, as is always true when it comes to investing, how you should go about chasing compounding returns will depend on your risk tolerance and investing expertise.

For those who are more risk-averse, keeping a steady balance in a brokerage account and making investments in less risky assets (like quality bonds) will provide stable but low compounding returns. For risk-tolerant investors, actively investing in riskier assets, from publicly-trading companies to private startups, can provide better returns, but are inconsistent, less reliable, and may result in loss, so invest wisely!

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