How well do you understand compounding? If you’re not sure, you are not alone: The 2020 OSC Investor Experience Research Study found that 31% of investors do not understand compound interest. As compound returns are one of the most critical concepts underlying long-term investment growth, it is important to know how staying invested and reinvesting for additional growth can lead to stronger portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition returns over time.
How compound returns work
Compound returns are possible when you reinvest interest or dividends earned from an investment.
For example, say you have a $1,000 investment that pays 5% interest annually. After the first year, you would earn $50. If you reinvest the $50 return along with your original $1,000 investment, you would earn $52.50 in the second year. You would then have compounded returns, effectively you are earning a “return on your return.” After five years, you would have earned $276.28 and the total value of your investment would be $1,276.28.
Compounded returns can only happen if you reinvest interest or dividends earned. This strategy can help grow the value of your investments faster and over a long period of time, there could be significant financial gains. If you invest $1,000 earning 5% annually and reinvest the returns each year, after 30 years, the value of the investment would grow to $4,313.30 compared to just $2,500 if the returns were not reinvested but kept as cash at home.
Compound Interest Calculator
Try this calculator and see how even small amounts can add up over time.
Are investors benefitting from compound returns?
While compound returns can mean increased portfolio growth and more financial assets over time, it only works if you stay invested. Often, investors can be tempted to sell out of investments during times of market volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition, such as the early and difficult stages of the COVID-19 pandemic.
Thankfully, that did not generally happen in Canada in 2020. The OSC Investor Experience Research Study found that while 47% of investors experienced increased stress during the early stages of the pandemic, 85% did not react by selling. Reactionary selling is a form of short-termism, which can be a hard trap to get out of and can lead to weak portfolio returns over time. Learning more about compound returns and other investment basics can help you avoid many of the common pitfalls of investing.
Harnessing the power of compound returns
A deep understanding of how compound returns work can be one of your most important tools to achieve your financial goals. See more of the Ontario Securities Commission’s resources for helping investors learn more about compounding and other investment concepts.