If you read investment related articles regularly, you would know by now the importance of compound returns. Given a long enough time horizon and a reasonable rate of return, a small investment made today can become a large amount in the future. All it takes is time, and compound returns.
While most investors understand the role that time plays when it comes to growing our portfolio, much fewer understand about the critical role that compound returns play.
Sure, we probably know the definition. Compound return (or compound interest as some prefer to call it) basically means, “earning return on our returns”.
This is an important concept for wealth building because by earning returns on our returns for each period, we are able slowly accumulate higher returns each period, compared to if we were only making returns on our original investment.
Here’s an illustration.
Adam invests $10,000 at a return of 5% per annum. The returns ($500) are given out to him in cash at the end of each year. Ben also invests $10,000 at a return of 5% per annum. Unlike Adam, his returns are automatically reinvested.
Here’s how much they will have at the end of five years.
Intuitively, most of us understand why Ben has a bigger portfolio than Adam after five years. By having his returns reinvested, Ben is able to generate higher returns in the later years.
Read Also: Feature: The Power Of Compound Returns
Is Your Investments Getting You Compound Returns?
Whenever we talk about long-term returns from our investments, we tend to use one simple formula to calculate them.
FV = PV (1 + I) ^ N
Where, F = Future Value, PV = Present Value, I = Interest, N = Number of Years
The bigger “N” is, the greater the compounding effect.
However, the big flaw here in most of our investment calculation is that we automatically assume that this formula is applicable to all types of investment.
However, it’s not.
The limitation with the Future Value Formula is that it assumes you can automatically reinvest any interim cashflow you receive from the investment, back into the investment itself, at the same rate of return.
However, that’s not always true. In fact, for most common investments around us in Singapore, this formula doesn’t really work.
A Classic Example: Investing In Properties
Singaporeans favourite investment pastime is investing into properties. We love the thought of buying multiple properties, and to rent them out for passive income.
Assuming a person invest $1 million, and is able to rent it out at $40,000 per year, his return would be 4% per annum, paid out through rental income. For simplicity sake, we will assume no other cost incurred, and that the unit is paid in full with no loan taken.
Over a 10-year period, it’s easy to see that total returns will be 40% (4% X 10). It’s impractical in this instance to think that the returns should be compounded. The reason is simple; a property investor cannot simply reinvest his annual returns back into the property, even if he wants to.
Sure, property investors can always reinvest the $40,000 into other investments to generate returns from it. But by doing so, he will facing a different rate of return.
As a simple rule of thumb, if you are investing into assets that give you a return in the form of a payout, there is a good chance that you will not always be able to reinvest your interim payouts at the same rate of return.
Which Investments Won’t Automatically Allow You To Compound Your Returns?
Now that we have explained why some investments don’t automatically give you compound returns, let’s look at which investments fall into the category.
Investments That Don’t Allow You To Compound Your Returns
Investments That May Or May Not Allow You To Compound Your Returns
Investments That Allow You To Compound Your Returns
Are My Returns Compounded?
Just because your investments fall under one of the groups that do not automatically compound your returns does not mean that you are not able to enjoy compound returns in your portfolio.
As an investor, you can use the cashflow you receive from your principal investment, and to reinvest them into other suitable instruments. For example, if you are receiving a 6% rental income from your investment properties, you can channel these funds into your CPF Special Account to enjoy a 4% return, rather than to leave the money unused. In this scenario, you are still making compound returns from your investments, just that it’s not the 6% you thought you were getting.
At the end of the day, compound returns is an area that you cannot afford to ignore if you want to grow your wealth over an extended time period. At the same time, you have to mindful of the investments that you are making, and to analyse for yourself if these investments are really giving you the long-term returns that you are expecting, and what you should be doing instead if your investments are not automatically giving you the compound returns you thought you were getting.