What is Compounding

Einstein once called compound interest the eighth wonder of the world, and warned that “he who understands it, earns it, and he who doesn’t, pays it.” But how does compounding work exactly? In our latest article we define compounding and illustrate its effect on a hypothetical 20-year investment.

Earnings on Earnings

Compounding is the process by which an asset’s earnings, for example, REIT dividends are reinvested to generate additional earnings over time. Simply put, compounding allows investors to earn interest on top of interest, and more on top of that. Initially the impact of compounding may seem insignificant, but the snowball effect it produces allows wealth to grow without much effort – so long as the earnings generated by the underlying investment remain consistent.

The Power of Compounding

As Warren Buffett said, compounding can transform investment earnings into an even more powerful income-generating tool. All an investor needs to take advantage of compounding is reinvested earnings and time. To demonstrate the power of compounding, let’s look at two hypothetical investment scenarios with a dividend-generating asset which has the option to be reinvested. Investor A and Investor B both purchase shares of an asset that produces a 6% annualized dividend paid monthly; they each purchase 2,000 shares at $5 per share:

With dividend reinvestment – Investor A opts to reinvest her dividends each month over the course of 20 years and nets a total value of $33,102.

Without dividend reinvestment – Investor B decides to receive dividends in cash each month instead of reinvesting. After investing for 20 years, he nets a total value of $22,000.

Over the course of 20 years, the investor who compounded her earnings generated an additional $11,102 of total income, without realizing any appreciation in the underlying asset value. Clearly, compound interest can become an incredibly powerful tool to build wealth in the long run. Investors looking to build for their futures or plan for retirement may opt to explore investment vehicles that take advantage of compounding, particularly in assets that are designed for steady, long-term growth.

*This hypothetical projection is based on an asset that produces a 6% annualized dividend, compounded monthly over the course of 20 years. This figure is for illustrative purposes only, there is no guarantee that the hypothetical earnings projection will be attained. All investments involve risks including possible loss of principal. Past performance is not indicative of future results.

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Disclaimer: This information is for educational purposes only, and is not intended to represent investment, tax, or other financial advice. Please consult a qualified tax professional regarding the applicability of the above to your personal situation and the specific requirements and limitations of the above.

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