The Magic Of Compounding!

When Albert Einstein, one of the most influential theoretical physicists of all time understood the importance of compounding, it pays for us to spend a few moments to appreciate this “wonder”.

What Is Compounding?

Investopedia defines compounding as the ability to generate earnings from previous earnings.

Say you invested \$10,000 into Singapore Airlines Ltd (SGX:C6L). In Year 1, the shares rose 20%, translating to a total value of S\$12,000. In Year 2, the stock rose by another 20% resulting in a year-end value of S\$14,400. Instead of rising by S\$2,000 like in the first year, your investments appreciated by an additional S\$400 as the S\$2,000 gained in the 1st year also grew by 20%!

What is CAGR?

CAGR (Pronounced as K-ger) is the acronym for Compounded Annual Growth Rate. It’s the year-on-year compounded growth rate of an investment over a specified period in time.

In reality, investment returns cannot be defined by one number every year. CAGR just describes the rate of investments if it grew at a steady rate.

For example, in the 1st, 2nd and 3rd year, the investment grew by 10%, 5% and 15% respectively. The calculated CAGR would be 9.92%, hence we can state that the investment grew by 9.92% on a compounded year-on-year over a 3 year period.

Of course, we won’t always have positive returns over our investment lifetime. Compounding is a double edged sword, that is why Buffett’s No.1 Rule is never lose money and his 2nd rule is never to forget Rule No.1. If you lose 50% in year 1, you would need to gain 100% in the next year just to breakeven!

The Magic Of Time With Compounding!

Why start young?

Assuming you start investing S\$10,000 per year when you are 20 at the start of the year, at just a 5% annual return, after 20 years at 40, you could end up with S\$357,192.52!

Compared to one who started investing in when they turn 30, to turn S\$10,000 to S\$357,192.52 in 10 years requires a CAGR of 21.88%!!! From my experience, if you can consistently garner a return of over 20% CAGR over a period of 10 years, you could potentially be placed alongside the great investment names.

Our previous article “Who Wants To Be A Millionaire” touched on the mathematical feasibility of being a millionaire with just a 20% saving rate and an average monthly income of S\$5,000 a month!

The Rule Of 72?

The rule of 72 is a very simplified method to approximate how long an investment would take to double. An investment with a CAGR of 10% would take ≈ 7.2 years to double. One at a CAGR of 20% would take just ≈ 3.6 years!

Just take a moment to try it out!

You would be amazed by how convenient this simple estimate would enable you to place your investments into perspective!

Check out how this trait of compounding would help you to identify great companies in our following article!