When you are investing your money, one of the key criteria is how to receive compounding returns.
Typically, investors are more than keen on mastering the concepts of compounding returns.
Though most times people are familiar with compound interest, they are never sure how to make it work for them.
Often, this is the key to maximize your returns from any investment.
You may argue that the rate of interest is crucial, but that is only part of the story.
Almost undeniably, receiving compounding returns is the best way to maximize returns.
This is how you can make your money work for you.
Is it factored in naturally into an investment plan?
Well, this is what you have to work out.
It is particularly important in the long-term investment plans.
As you know, many a penny makes a pound.
So, with compound interest, you have to make every penny work overtime for you.
This investment method helps you optimize the value of every penny you put in.
Moreover, you also get an advantage of investing for an extended period.
So if you are planning your retirement savings, you need to master compounding returns.
There are four primary steps for you to achieve this
- Create a savings account that promises the rate of return
- Invest the interest earned back into the main savings
- Reallocate the earnings to a higher risk, higher return portfolio
- Diversify the investment tools
If you notice, all of these follow basic compounding principles.
They are focused on not just the basic interest you earn.
It is about using the same amount of money to broaden the earnings prospect.
The idea is to create multiple forums to draw earnings from the same source.
Decoding the Law of Compound Interest
Before we proceed any further on how exactly we plan to earn compounding returns, a grasp of the fundamentals is crucial.
What exactly is compound interest and how can you benefit from it?
In simple terms, it is interest on basic investment and interest on interest earned.
So, all additional earnings from a single investment are reassigned to the main principal.
As a result, this principal keeps increasing in a slow and steady fashion.
Needless to mention that this will impact the extent of interest earned as well.
So whether you earn a dividend on your investment or pocket some profit, you can channelize it back.
So the additional money helps to multiply your money by many-fold over long-term.
This concept can be explained by a simple formula,
A = P (1 + r/n) (nt)
In this context, A stands for the final investment value.
P is the principal that you have invested originally.
R is the rate of interest on an annualized basis
T is the time period for the investment
N stands for the number of times this interest is compounded.
So your final amount is then taking into consideration this compounded return for n years.
So every year of n years, you have been able to earn a little extra interest from the previous year.
If you can compare this with the simple interest, you can compare the difference.
In the latter case, the investor’s rate of return remains constant.
But thanks to compounding interest, in the former case, there is significant growth.
Therefore, a compounded return is a way more accurate measure of expected return.
But at the same time, this is an average growth perspective for the investor.
It will be difficult to measure the exact growth in a specific year.
Example of Compounded Return
Let us now consider an example of compounded return.
That will help you understand how you can draw meaningful gains from this.
Let’s assume that you have invested $10,000.
So what will be the interest after one year?
Let us say that the rate of interest is 1.05% and you calculate over a 12-month period.
According to the formula, it will be,
So the final amount will be, $10,105.51.
So how has compounding returns helped you?
The interest that you earned in the first month is $8.75
But by the sixth month, it is $52.61.
Needless to mention, by the 9th month, it increased even further.
Well, this is because, every month, it has helped you enhance your capital a little extra.
The power of compounding returns helps you clock in additional interest.
You can easily achieve this by choosing to invest in a savings bank with a higher rate.
Of course, you have the option to either claim the amount at regular intervals.
In this case too, you will be able to access additional income without disturbing the base capital.
Therefore this is a step by step method in which your capital gets enhanced.
So, in simple terms, you get the advantage of income over income.
This is how you can receive compounding returns on a longer-term period.
It is understood that more the number of years you invest for, higher the extent of returns.
But there are many myths surrounding these compounding returns.
You have to take a constructive view and make an informed choice.
So as an investor, you need a clear view of how can investors receive compounding interest.
While the theoretical elements are easy to understand, you have to pay attention to details.
That will ensure long-term gains.
Decide on Your Risk Level
From stocks to bonds, investors can receive compounding interest on a variety of instruments.
But the problem is that the scope of return will differ from investor to investor.
The degree of risk you are comfortable with will determine the final value.
It will also help you choose the specific instrument that can help deliver the returns.
But this will vary from individual to individual.
The final rate of interest that you are comfortable with and the risk is crucial.
This will help you create an effective investment structure.
That is what will help maximize the return potential.
This is particularly useful for retirement accounts where you have to invest over a long-term.
In fact, compounding returns helps only with the right choice of investment instrument.
The overall rate of interest is closely linked to the specific tenure and type you choose.
In most cases, the associated fees and other charges impact on the compounding returns.
A systematic approach, therefore, is crucial.
When you marry that with the appropriate time period, you can realize absolute value.
But with all that, the risk level takes up a key role.
That is what decides the ultimate extent of returns.
The risk profile is crucial to the overall time duration involved.
Even small amount of compounding returns can introduce meaningful gains.
The trick is that per se, the compounding returns don’t appear large.
But when you assimilate this amount over the longer term, you can realize the exact value.
If you notice the gradual increase, sometimes the difference between 5-year rate and 10-year can be huge.
In many cases, investments double between 5 years.
So the risk level dictates how effectively you can achieve the benefits.
Therefore, receiving compounding interest is a function of risk and market levels.
Time Is a Crucial Factor
When you are looking at receiving compounding returns, time is often the other most important factor.
The beauty of compounding returns is only manifested over the longer term.
In fact, the longer you can invest your principal, the better the returns.
Often, more than the risk or the type of instrument, it is the time element that makes the difference.
Your overall return is significantly impacted by this.
Let me explain to you by an example.
Let’s say I am investing an amount at 6% interest for 4 years,
I will get an X amount after 4 years.
But my returns in 8 years will be 2x.
What I notice is every 8 years, my return doubles.
So my returns in 24 years will be significantly higher.
But the interesting aspect is, neither have I deployed larger capital nor a higher rate.
A simple math of compound interest ensures that I can earn a whole lot higher return.
But the problem that investors often battle with is the temptation.
The compound interest is accrued over a certain regular time interval.
If you spend this amount instead of adding to your principal, it is of no use.
This will then not help you in earning compounding interest.
In fact, it can even reduce the overall interest that you earn.
This is because, in case of long-term compounding returns, it averages out a few low-interest income years.
The simple reason is that the base principal keeps getting enhanced every year.
However, that is not the case if you redeem the interim interest every now and then.
This then significantly reduces the overall interest and hence your long-term capital too.
So, systematic investment plan is important.
When you back that with long time duration, compounding returns increase.
Inflation is another major hindrance when you consider ways to earn compounding interest.
Inflation, in simple terms, assesses the affordability at a current economic period.
So it implies the rate at which your current savings will decrease in value going forward.
For example, you may feel $50,000 is sufficient to meet X expense.
Bu in 10 years’ time, you may need $80,000 for the same expense.
In that context, it becomes a tricky calculation.
Your investment has to be designed such that it accounts for the additional 30,000.
Well, the good news is compounding interest is perhaps the best way to achieve this.
But the bad news is that you have to use it in an efficient manner.
Otherwise, the relative rate of interest will tend to yield a much lesser amount over a longer duration.
Let us use another example.
Let’s assume the rate of inflation is growing at 4-5% levels.
While this is not alarmingly high, it is quite a bit of additional cost in future terms.
The question is how you can handle your investment to account for this additional 4% every year.
Because in close to 20 years, the money you are investing now may have reduced by half.
This will then crimp your savings significantly.
Well, this is where you will have to assess your returns carefully.
More than that you have to also note the relative expenses incurred.
It is surprising, but the fact is just by enhancing your investment by 2-3% a year, you can get very high returns.
Well, this is again due to the benefits of compounding returns.
It helps you optimize even the smallest increase in your overall kitty.
That will then help you brace for uncertainties like inflation in a significantly better fashion.
Effective Compounding Returns From ETF?
When you consider how investors receive compounding returns, it is important to look at individual instruments.
That surely delivers compounding returns, but it is generally a much lower level.
This is because the rate of interest in a savings account can never compete with stock markets.
Let us first consider options with comparatively lower risk profile.
The Exchange Traded Funds, in this respect, provides a reasonable option.
It gives you the flexibility of stock markets but at the same time, relative safety.
The good part is that the fees are also much lower in this context.
The fees in case of Exchange Traded Funds are almost 80% lower.
So there alone, you have a considerable amount of extra money to plough in.
So just by choosing this instrument, your returns can increase to a certain extent.
But there is one problem with ETF.
Your tax liabilities are greater.
So in this context, the lesser you trade, the better you can defer the liabilities.
So when you are making an overall assumption, you have to take a comprehensive picture.
This will help you make a realistic assumption about returns over the longer term.
But when you are calculating your returns, you have to also consider certain factors that impede.
There are many factors that can limit overall return expectation.
It can be the economic condition or the overall market levels.
The geopolitical equation in the country will also have a bearing on the money you earn.
It is exactly for this reason that you have to look for all potential risk factors.
But when you consider a specific exchange-traded fund, it may help you garner favorable returns.
This is how you can optimize gains.
Can Stocks Help You Receive Compounding Returns?
When people ask me how investors can receive compounding returns, I always look for unconventional avenues.
By this I mean, we already know the easy compounding return targets.
But the investment arena is always replete with unrealized avenues that can yield high returns.
A quick study of these will help you create a conclusive investment basket for future.
This is where you can use your investment in stocks for compounding returns.
Well, you may have heard about diversifying investments.
Well, it is time to try it out here in the stock markets.
Suppose I buy a stock that also offers me a yearly dividend.
I have two options; I can either spend this money or reallocate it to my investment.
Well, I choose to invest the money.
I can either buy more stocks with this money or else I can put in in a fixed deposit.
I can even buy other forms of investment like Exchange Traded Funds.
So effectively what am I doing?
I am using the same principal amount to earn income from the income.
This is the basic of compounding return.
So in many ways, the beauty of compounding returns is also dependent on interpretation.
As long as you are using your current earnings to generate higher earnings, it is compounding returns.
So, How Can Investors Receive Compounding Returns?
Bonds, Mutual Funds, Annuities are all good source of receiving compounding returns.
Investors, however, have to be mindful of the source they choose for compounding returns.
The overall tax liability and inflation will have an important bearing on final returns.
While compounding will help increase your wealth additionally, you have to judge the extent you need.
A realistic calculation of future liabilities is crucial.
But with all that in place, you can definitely earn higher by making sure you receive compounding returns.
Remember the trick is to make your money work using the formula for compound interest.
You can achieve this with This System in the best possible way while there is no risk at all.