Understanding The Power of Compound Interest

Learn about the magic of compound interest – and the amazing impact it can have on your investments.
Woman stacking coins.
Compound investing is a poorly understood yet oft-touted concept that’s vital to growing money for long-term goals
Albert Einstein is rumoured to have called it one of the greatest inventions in human history, but you don’t need to be a genius to understand the power of compound interest investing.
Compound investing is possibly the most touted investing concept ever; yet, many people don’t know how it works as it can be a bit complicated to understand. Robert Ironside, a professor of finance at Kwantlen Polytechnic University in Surrey, B.C., explains compound interest this way: “The amount of interest is calculated, paid out and reinvested, and then both the initial principal and the accrued interest earn interest for the next period of time.”
That might not sound all that earth-shattering – until you see the numbers. Say you invest $100 and earn a 5 per cent rate of return. The $5 you earn in the first year will then gets reinvested along with the initial principal. So, the next year, you’ll have $105 earning 5 per cent, which nets you $5.25.
That might seem like a small increase at first but, over time, those numbers can rise significantly, says Mark Seed, an Ottawa-based financial expert who writes about dividend investing strategies at myownadvisor.ca.

Make more money

To understand just how significant compound interest is, consider this example: “Over a month of investing,” asks Seed, “would you rather be paid a penny on day one, but that money doubles every day throughout the month for 30 days? Or would you rather be paid $100,000 per day, every day, for the entire month?”
Most people would choose the latter. That’s a mistake, because the penny is compounding by 100 per cent each day, resulting in about $5.3 million over 30 days. Opting for the $100,000 per day, meanwhile, would result in just $3 million over the same period.

“To really take advantage of compound interest investing, you’ll want to make regular contributions to your portfolio.”

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Keep contributing

To really take advantage of compound interest investing, you’ll want to make regular contributions to your portfolio, says Kyle Prevost, a personal finance teacher at a high school in Manitoba. They don’t have to be large deposits – small ones grow into a significant sum over the long term. “If you can save and invest with discipline then you can make (a lot of money),” he says. “Start early enough, understand how investments work, and stick with a basic plan.”
It helps to have a diversified portfolio as interest-bearing investments, such as bonds, typically offer lower compounding returns than the stock market, says Ironside. He also stresses the impact of fees on compounding returns. A 2.5-per cent fee on annualized returns of 10 per cent over 40 years results in 60 per cent less wealth, he says.
“What this boils down to is that when it comes to compounding returns on your investments, small differences over long periods matter a lot,” says Ironside. “It’s just that sometimes you need to see the numbers laid out in front of you to realize the impact.”

Get started

As the old adage goes, the best time to get started was yesterday; the second-best time is today. Investing is a long-term commitment and the earlier you invest, the longer compound interest can work for you.
Investing also takes dedication to making regular contributions. Your investing platform likely allows for regular, pre-authorized payments. These are a great way to make sure you reach your investing goals each month by paying yourself first. It’s a great “set it and forget it” approach that will help you build your portfolio over time – and take full advantage of compound interest.

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