You’re working hard, and you want to make the most out of your savings. You’ve probably heard of compounding returns, but do you really know what that means? If not, it’s time to roll up your sleeves, dig in, and find out.
Compounding returns are a powerful concept. So much so that the entire American economy runs on it. Now, the thing is, you can put compounding returns to work on your own portfolio. You just need to understand what to do and why. Curious? Read on.
- What Is The Magic Behind Compounding Returns?
- How Investments Can Offer Compounding Returns
- Invest In The Right Products to Receive Compound Returns
- Tax Loss Harvesting
- Buy-and-Hold Strategy
- Investment Always Carries Risk!
- The Sooner You Start, The More You Will Earn
What Is The Magic Behind Compounding Returns?
According to thestreet.com, a compound return is when the value of your investment grows based not only on the original principal amount but also on the returns that investment is generating.
Let’s take a simple example. Say you put $100 into an investment with a 10% annual compound interest rate. At the end of the first year, you have $100 principal + $10 interest, giving you $110.
Now, because this is compound interest, your second year will pay you 10% on $110, giving you $121. Your third year will then pay you 10% on $121, giving you $133.1, and so on. In short, every year, you reinvest the principal plus whatever interest is earned.
There is a risk, as always. Provided the markets go up a big part of the time your money is invested, you stand to win big. But the opposite is also true. Historically, though, the longer you let compounding returns work, the more likely an overall positive result.
How Investments Can Offer Compounding Returns
An investment product must meet two basic requirements to qualify for compounding returns.
- It must pay returns to the asset holder in the form of interest, dividends, or some other income stream. It cannot be an asset whose value can only be realized by selling it off.
- The investment must then take those returns and reinvest them in the underlying principal, which is then used to calculate your gains.
There are two main ways in which a qualifying investment product can offer compounding returns.
- Interest Payment: such an investment will have a fixed rate of return calculated on the underlying principal. All gains are added to this underlying principal to increase the rate of return.
- Asset Holdings: here, the investment is a collection of assets, such as a stock portfolio. The asset gains value from any income generated by its holdings. Gains are, in turn, used to buy more assets, increasing the number of ongoing income-generating holdings.
Invest In The Right Products to Receive Compound Returns
There is a variety of investment products offering compounding returns.
Certificates of Deposit (CDs)
Investopedia explains that a CD is a savings product offered by most consumer financial institutions. It offers a fixed interest rate on a lump-sum of money for a predetermined amount of time, which could be months or years.
CDs are a great investment option because they’re covered by the FDIC up to $250,000 per person, and are zero-risk. You can store any funds you don’t currently need in a CD and watch your money grow.
It is another excellent way to compound your returns. You can visit nerdwallet.com for an in-depth look at mutual funds. Put simply, they work by pooling cash to buy stocks and other assets. It’s a cheaper way to invest while hedging losses.
Most mutual funds don’t pay dividends to investors. Instead, they reinvest the funds into buying more underlying shares. The fund continues to earn compounding interest by purchasing more and more shares. Also, most mutual funds pay a lower tax rate than the individual tax rate, an added benefit.
ETFs (Exchange Traded Funds)
If you are a DIY investor, this could be for you. Several ETFs offer DRIPS, or distribution reinvestment plans, which you can take advantage of to compound your returns.
ETFs typically invest in dividend-paying stocks. A DRIP allows you to exchange any dividends you earn for more shares of the ETF, compounding, and growing your returns over time.
Check out Forbes for a guide on the differences between mutual funds and ETFs, as well as the pros and cons of this product.
Also known as a deep discount bond, a zero-coupon bond is different from traditional bonds. These bonds have no interim cash flow. The bond trades at a discount to its face value.
Alexander Voigt, the founder of daytradingz.com, gives a simple example. A $100, 5-year zero-coupon bond offering a 5% yield will be priced at $78.35. In short, you lend $78.35 and receive $100 in five years’ time.
You’re thinking, I already have a couple of these investment accounts going for me. What else can I do to diversify and earn more compounded interest? Well, there are some investing strategies you can use to make compounded interest.
Tax Loss Harvesting
Harvesting tax losses refer to selling securities, which have faced an unrealized loss to offset income and capital gains. Say you buy two stocks, A and B, each at $100. Stock A rises in value to $120, while B falls to $90.
You can use the loss to offset the taxes owed on the gain. If you don’t harvest, your tax bill, assuming a capital gain tax of 15%, will be $20 *0.15 = $3. If you do harvest, your tax bill is instead ($20-$10)*0.15 = $1.5.
The idea is that be harvesting your loss; you can reinvest the $1.5 back in the market and continue to earn compounded interest. Nicolas Allen of The Business Journal explains the ins and outs of this strategy.
It is a passive strategy with a simple belief: time in the market is a more prudent investment than timing the market. A buy-and-hold investor believes that long-term results can be reasonable despite any short-term volatility in the market.
You can pick individual regions, sectors, and stocks to invest in, but the ultimate goal is to hold your investments long-term. You aim to take advantage of any future price appreciation while avoiding the taxable consequences of selling your holdings.
Buy-and-hold is not suitable for everybody, though, as it completely ignores the concept of risk management. Check out Financial Mentor for the pros and cons of this strategy.
Investment Always Carries Risk!
Everybody wants investment schemes that offer high returns in a short period of time with little or no risk. Instead of falling prey to scams promising you instant riches, do your research well, choose your strategy, and manage your risk portfolio.
Check out Ryan Scribner’s video, Compound Interest $10k to $452k. Scribner is a young but proven entrepreneur and shares his successful investing tips and strategies. He explains what strategies to use in which situations and why.
The Sooner You Start, The More You Will Earn
Compounding your returns is not risk-free, but it can be a powerful way to grow your income if well-managed. We’ve gone over what compounding returns really means, as well as the various investment products and strategies you can use to receive them.
And you don’t have to dive off the deep end either. Take the time to research a product or strategy that appeals to you before investing so much as one cent. Shop around for the best products and offers before committing yourself.
Once you have picked your strategy and decided on which products to go for, prepare to be patient. If you commit your money wisely, your investments should pay you handsomely in the long run.