Disclaimer: this blog post contains general information. This is NOT personal financial advice and should not be acted upon. Please speak to your financial advisor or accountant about your specific situation before making any investment decision. This article was originally written August 2022.
The concept of compounding is a crucial element in the world of finance. It is often said that "money makes money", and this statement holds some truth.
Compounding is the payment of interest on previously accumulated interest, and it can occur at any level of investment, at any timeframe - it can occur daily, weekly, monthly, quarterly or annually. What's most important, is that it is HAPPENING! Never forget that, especially when you're only starting your journey into investing.
Compounding is the key to success, as the more income you can accumulate and reinvest from your assets, the more you will then accumulate to reinvest - and the cycle goes on.
I like to think of compounding as a snow ball rolling down a hill, gathering pace and size as it goes. Remember, it starts out small and gains size by the effects of compounding growth on growth, so don't feel discouraged if you don't have a lot to start with. It's meant to be a grind at the start, but once you start accumulating and reinvesting, the more you will be able to accumulate to reinvest.
Compounding can be achieved purely through income-based investments. As an example of compounding, buying a Blue Chip stock that has a steady price and positive income yield, you can see the effects of compounding. Reinvesting the income to purchase more units of that stock can look something like this:
Now this is obviously a very basic example; as capital value changes, yields change as company profits change and this example also does not consider further investment into the portfolio or any withdrawals. But it provides you with the basic idea that reinvesting income into more units, can produce more income from those additional units of investment.
It also helps when the capital value of the stock rises over time too, but I like to keep focus on income. Here's an example of if there was slight growth of the stock value too:
The good thing is, this is not purely limited to the stock market either - I just used that as an example as it's relatively easy to get into the stock market with a small amount of money.
Property investment can be another way to use income compounding to make more money - think about it this way: if you purchase a rental property with a positive income yield (meaning the rent you charge covers the loan repayments and other costs), you can use that income along with the equity* in the property, to accumulate further property and start the process of compounding.
Equity can increase even with an investment property that appreciates slowly in value or only maintains it's value. Hear me out; if you are paying Principal and Interest off your loan and your rental income covers those costs, you will reduce your debt over time and thus increase equity. Here's a quick basic example, simply showing the capital value being maintained and the loan being paid down at the minimum level:
The rules on accessing equity will vary from state to state, so check the rules on accessing equity in your own area before using this approach. For example, in Queensland, Australia (where I'm from), usable equity is worked out as: (Property Value x 80%) - Outstanding loan balance
Of course, if you have positive cashflow from property, you can either save it or put additional funds towards the loan, which will increase the rate by which the equity grows. Also, in the real world, the capital value of the property would also fluctuate, so assuming a modest growth rate, your equity should grow even faster over time. (But let's not bank on it - past performance is NOT an indicator for future performance!)
Keep in mind - it will likely take longer to accumulate your first or second property than it will to purchase further properties thereafter, if all works out well. The more properties you acquire and apply the above concept to, the more equity you will build within your portfolio and likely at a faster rate too, enabling you to accumulate deposits for further properties even quicker.
The examples I've provided above are both just very simplistic examples on stocks and property, but the concept of compounding should be a bit clearer to you now. An important thing to consider with compounding, is to not disturb the process of compounding by constantly selling assets or changing strategies because of market fluctuations. Patience is key.
Disclaimer #2: Once again, I have to remind you that this blog is NOT personal financial advice. The article is written to open up your mind to concepts that can be applied in investing. Please speak to a financial advisor or accountant about your specific situation before entering into, or out of any investments!!