Last Updated on December 6, 2019
In the simplest of terms, compounding returns are the reward you get for rolling over previously earned returns on a particular investment. Rolling over means reinvesting profits or gains on an investment (underlying principal) instead of consuming them. So, the compounding return is a cumulative reward based on principal investment and accrued returns.
A Practical Example of a Compounding Return
Assume you have an investment, say a certificate of deposit (CD) at an annual interest rate of 12 percent. A certificate of deposit is a term deposit. It’s an investment offered by financial institutions such as banks. They carry zero risk thanks to cover by the Federal Deposit Insurance Corporation (FDIC) to the tune of $250,000 per investor.
The bank withholds your savings for a specified period and pays you the agreed interest as your annual return on the CD. During the withholding period, the funds are inaccessible. Make sure you don’t put, for example, into a one year CD funds that you’re likely to need within the year.
A $50,000, three-month CD at an interest rate of 3 percent earns you $1,500. The CD matures after three months. Upon maturity, you can request the principal investment ($50,000) and $1,500 return from the bank. You can also roll over the CD for another three months and earn $1,545. You’ll notice that the return on the CD after the consecutive three-month period is $450 higher than on the preceding three month CD horizon.
That’s the nature of compounding returns, and in the case of CDs, it’s safe to call the cumulative returns interest on interest. From the example above, the investment principal is $50,000, and the cumulative returns are $1545, $1591.35, and $1639.10, respectively. A $50,000 CD in January cumulatively grows to $56,275.45 at the end of the year. And you can roll it over, time and again, as many times as you wish because banks don’t mind using it as part of their credit reserves.
Conditions That Favor Compounding Returns
For an investor to receive compounding returns, two factors matter:
- The type of financial asset, which could be a short term or long-term financial product and
- The potential and rate of compounding returns from a particular financial asset
Financial Assets That Can Earn You Compounding Returns
Certain types of financial assets don’t have compounding potential because their value is only realizable upon selling them. For instance, if you have a contract for difference, the most you can get is a profit if, at contract time, you’re able to unload it at a higher price than you acquired it.
The same verdict applies to options and futures. Apart from giving you leverage in terms of price protection and hedge against volatility risk, you really can’t hold on to them in hopes of earning compounding returns.
Do this instead; buy and hold financial assets such as a portfolio of stocks, CDs, mutual funds, Exchange Traded Funds (ETFs), treasury bills and bonds and money market instruments, and corporate bonds. You can buy any or all of these financial assets and earn compound returns from them.
Buy high-value stocks such as growth day trading stocks and dividend stocks: this way, you’re assured of consistent price appreciation over time and dividend payouts every financial year. That’s an essential catalyst for compounding returns.
Carefully chose your hybrid financial assets (funds) so that they’re an optimized mix of profit or income-generating products to avoid stagnation. Go for short term to intermediate fixed financial instruments (bonds, bills, and commercial paper) as these earn you compounded income relatively quick.
You can invest in a 90-day, 180-day, or 360-day Treasury bill. It’s up to you, and the compounding returns you want. Zero-coupon bonds are the best. They’re already structured to pay compound interest. Plus, a zero-coupon bond has a fixed interest rate and retirement date: pointers that can help you plan your compounding return goals.
The compound returns from these financial assets can take the form of either distributed dividends or capital gains income for stock portfolios and pooled funds. And interest income from bills, bonds, and money market assets. The dividend and income earned can collectively be reinvested and compounded based on the underlying principal investment in any of these financial products.
Over time the compounding returns result in wealth generation that can go toward personal financial planning such as a college fund for your kids or even capital for your retirement career. Moreover, compounding returns is the way to go to build your retirement funds—401k, 403b, or an IRA account.
Even as you chase after financial assets that’ll earn you compounding returns, remember to use sustainable investment strategies. Exercise the passive investment style for your non-fixed income assets, especially stocks.
Be disciplined enough to hold your stock positions even in episodes extreme of volatility. As long as you’re smart in picking the right stocks, you’ll earn compounded returns. It also helps in avoiding the stress of tax consequences by not having to sell stock or reposition the portfolio.
You can also employ the Warren Buffet strategy to buy and hold stock positions for the long term. All you have to do is diversify by buying shares based on sector, region, and market capitalization. Buying and holding superb assets unlocks the full potential of compounding returns in anticipation of price appreciation and a higher dividend per share.
Another little known gem in compounding returns is tax-loss harvesting. It’s a tax-saving strategy that uses capital gains to offset capital losses. You sell the security-such as a stock- that has registered a loss. Tax-harvesting or loss realization helps to offset capital gains income taxes. Be sure to replace the sold security with a similar one to balance your asset allocation and projected compounding returns.
Types of Investment Accounts
In the same vein, work with the right investment account to optimize your compounding returns. You have a choice between three types of investment accounts. One is the deferred capital gains account. It’s the most standard account by far. With this account, you only get to pay taxes on capital gains once you sell the security that has gained. The 401(k) falls under this description.
The other two are unrealized gains taxable accounts and tax-free savings account (TFSA). In an unrealized gains account, account owners are allowed to accumulate capital gains taxes and remit them at the end of the year. The account is a bit of a rarity in most jurisdictions, though it doesn’t hurt to know about it.
A TFSA is a one-of-a-kind investment account. All contributions, interest income, capital gains, and dividends are tax-free. It’s a familiar account in Canada, and account owners can withdraw their funds at any time without paying a cent in taxes.
That’s just about it on compounding returns. For you to win at this game, you’ll need a financial planner and investment adviser on your side. In a rapid financial sector, you need all the help and direction you can get. To earn the most compounding returns, you’ll need to be patient and play the long game.
That’s not to say that day traders and other short-term investors can’t enjoy compounding returns. Day traders can just as easily have an investment plan to garner stocks with high capital gains margins. The only catch is that the fast-paced mode of short-term investment styles potentially can jeopardize your compounding returns. You’re better off taking your ample time and playing safe.