Disclaimer: This post is just for educational sharing purposes. Please do your own due diligence on any products mentioned in this post.
There is a quote on compounding attributed to Albert Einstein:
Compound interest is the eighth wonder of the world.
However, Quote Investigator has found no substantive evidence that Albert Einstein (and many others this quote was attributed to) had said it after conducted extensive research.
Nevertheless, the concept of compounding is indeed an amazing wonder behind the principle of successful long term investing.
To illustrate why compounding is such an amazing wonder, let me put forward a question:
Would you rather have a penny that doubles everyday for a month, or $1 million up front?
Many uninitiated people would likely choose to take the $1 million. After all, how much can 1 penny double to in 30 days? They would be surprised that the penny would grow to more than $5 million by day 30, all due to the amazing power of compounding.
You may read an article on this question at the following link:
https://thecollegeinvestor.com/17145/would-you-rather-have-a-penny-that-doubles-each-day-for-a-month-or-1-million/
What is Compounding?
An Investopedia article on the topic of compounding described it as:
https://www.investopedia.com/terms/c/compounding.asp
Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.
We can see from the description that there are 2 kinds of compounding in investment:
- Compound Interest (compounding due to earning from interest)
- Compound Growth (compounding due to earning from capital gain)
Through my involvement with the 1M65 and Seedly communities, I realized most people has no problem understanding compound interest, but some are having trouble understanding how compound growth works.
Compound Interest
An Investopedia article on Compound Interest defined it as:
https://www.investopedia.com/terms/c/compoundinterest.asp
Compound interest (also known as compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.
The formula for Compound Interest is:
Bank fixed deposit (FD) account would be one such asset that generate compound interest. For example, lets say we invest $10,000 in a 12-month 2% p.a. FD and let it auto roll for 3 years.
At the end of year 1, the FD account is credited with $200 ($10,000 x 2%) and grow to $10,200.
At the end of year 2, the FD account is credited with $204 ($10,200 x 2%) and grow to $10,404.
At the end of year 3, the FD account is credited with $208.08 ($10,404 x 2%) and grow to $10,612.08.
In other words, the previous year interest is added to form the new principal in the current year, exhibiting a compounding effect that increases the principal at a faster rate in subsequent years.
The essence of Compound Interest is that there is an increase in the principal. Once interests credited, they are ours and they enlarge our principal.
Compound Growth
When an asset doesn’t generate interest, but instead grow its asset value, the compounding effect is achieved by capital gain, and this is known as Compound Growth. The measure of the asset’s growth rate is known as Compound Annual Growth Rate (CAGR):
https://www.investopedia.com/investing/compound-annual-growth-rate-what-you-should-know/
Compound annual growth rate, or CAGR, is the mean annual growth rate of an investment over a specified period of time longer than one year.
The formula for CAGR is:
A common asset that generate compound growth is stock that doesn’t give dividends. For example, Warren Buffett’s investment vehicle Berkshire Hathaway (ticker BRK.A) had never paid any dividends since IPO in 1980. The 10-year snapshot taken from the monthly chart of BRK.A on TradingView shows that its share price grew from $126,559.88 on 31 Aug 2012 to $421,308.00 on 31 Aug 2022:
Based on these prices, we can compute the CAGR of BRK.A to be (421308/126559.88)^(1/10)-1 = +12.8% p.a. One would realize from the formula that CAGR would be different if we compute based on different beginning and final values across different periods with different number of years in between.
Unlike Compound Interest asset where there is an increase in the principal, we still hold the same number of shares in Compound Growth asset, and the share prices keep changing. One moment we see the shares gained +10% since we bought them, the next moment it may even turn into losses. This kind of uncertainty leads some people into asking the following questions:
- My shares don’t give dividends nor additional units. How does compounding work with no increase in my holdings?
- How do I secure/realize the capital gains from the compound growth of my shares?
- Is it advisable to sell my shares to realize the gain now and buy back later to participate in the next phase of growth?
- If I sell now, what if the share price continues going up and I’m not able to buy back at a price lower than my sell price?
- If I don’t sell now, what if the share price tanks and my capital gain is diminishing or even turning into loss?
A common theme under all the above questions lies in the fact that compound growth is unrealized until we liquidate the investment. Some even called it an illusion.
So, how does compounding work with no increase in our holdings? To answer this question, lets look at what determines the share price. Here I present a quote from Warren Buffett:
Yes, ultimately share price is determined by the value of the underlying business, both the top line (revenue) and bottom line (profit). There will be short term fluctuation of share price, but it will reflect the fundamental business value of the company in the long run.
When a company is profitable, they can either pay out some portion of the earnings as dividends, or plough back the earnings into developing more products, creating better product mix, expanding business into more regions, etc. to grow their business. The latter case is where compounding happens, earnings is used to grow the business value further, generating more earnings to be ploughed back again, and the cycle repeats itself.
To benefit from compound growth, one key factor is the time horizon in holding the asset (Time in Market). Trying to sell high buy low along the way (Timing the Market) proved to be difficult to do consistently for most people.
The essence of Compound Growth is that there is an increase in asset value, but not the units of the asset. Hence, CAGR will change from time to time as the asset value can keep changing over time subject to market supply and demand forces.
Compounding Assets
Lets take a look at some common assets and determine whether it is a compounding asset, and if so, identify the kind of compounding effects they exhibit.
Central Provident Fund (CPF)
This is obviously an asset with Compound Interest. CPF interests are computed monthly and credited yearly. When interests are credited, it increases the principal in CPF accounts, meaning the compounding effect is happening yearly.
Insurance Savings Plan
In recent years, insurance companies began to offer insurance savings plans. Some examples are:
When Singlife Account was first launched in March 2020, they offered an attractive 2.5% crediting rate for the first $10,000 in the account and garnered 40,000 downloads within the first month of release (according to this report). With such successful launch, a few insurance companies followed suit with their own brand of insurance savings plans.
Insurance Savings Plan is an asset with Compound Interest. Its interests are credited monthly, therefore the compounding effect also takes place monthly.
Cash Management Solution
Another popular asset are cash management solutions offered by robo advisors and brokers:
- StashAway Simple / Simple Plus
- Endowus Cash Smart Secure / Enhanced / Ultra
- Syfe Cash+
- MoneyOwl WiseSaver
- SquirrelSave MoneyBox
- Moomoo Cash Plus
- Tiger Vault
StashAway Simple was the first cash management solution launched in November 2019, offering a projected rate of 2.1% p.a. (refer to their StashAway Simple announcement). Many more such products appeared subsequently.
If you read through all the marketing pitch on these kind of products, you might go away with a misconception that they are simple interest-bearing products, similar to bank deposits. Naturally you would think these are Compound Interest asset.
But if you dig a little deeper, you will realize that all of them invest in cash funds (e.g. money market funds, enhanced liquidity funds, short term bond funds, etc.). These are investment products (albeit the lower risk type), not deposit accounts. As all investment come with risk, cash management solutions are not capital guaranteed, and you may suffer losses when you need to withdraw cash.
Therefore, Cash Management Solution is an asset with Compound Growth. Its compounding is based on an increase in the asset value.
Dividend Stock
This kind of asset exhibits both Compound Growth and Compound Interest. The former comes from share price increase (or negative growth if share price decrease), and the latter comes from scrip dividends.
With Compound Interest, the principal is the number of shares owned, and the interest is the scrip dividends given and added to form the new principal for subsequent scrip dividend payouts.
As a side note, if the dividend stock investor opt for receiving dividends in cash instead of scrips, the principal remains the same and there is no compounding effect on the number of shares in the holdings. This is known as Simple Interest, in contrast to Compound Interest.
Exchange Traded Fund (ETF) / Unit Trust (UT)
Exchange Traded Fund (ETF) and unit trust (UT) has become popular investment instruments these days as the fund houses and distribution channels had been driving down the cost of investment to a reasonable level. The investment cost includes Total Expense Ratio (TER) charged by the fund house and brokerage/management fees charged by the distribution channel.
There are 2 types of ETF/UT, the distributing class and the accumulating class. The former would pay out dividends in cash, and the latter would re-invest dividends collected from its underlying shares. Both are Compound Growth assets, but the distributing class is having Simple Interest and the accumulating class is having Compound Interest.
Key Takeaway
- Compounding is a key success factor in long term investing.
- Compounding can happen through interest (Compound Interest) and/or capital gain (Compound Growth).
- The essence of Compound Interest is an increase in the principal.
- The essence of Compound Growth is an increase in the asset value.
- Be patient and give your asset time to compound and grow at an increasing rate.
On the last bullet point, I leave you with another quote from Warren Buffett on Patience:
Personal Wealth Life Cycle Management (PWLCM) 