Compounding: The Only Certainty in InvestingAugust 3, 2018
We live in a world where computer-generated investment algorithms, jumpy traders selling stocks due to tweets by the US President, talking heads and savvy gurus confidently explaining why their last set of predictions were so wrong, and copious amounts of data wash over us like a never-ending tidal-wave. What’s more, different investment strategies are being used by professionals in which many have never heard of and that may or may not produce desired results. Everyone pointing us in the direction of the next great way to invest or the next sure-thing.
However, just like in life where the only real certainties are death and taxes, the only certainty in investing is the concept of compounding.
When purchasing a share of a company or a unit in a trust that pays out a dividend/distribution, investors can choose how they will receive any future payment: either receive the cash or purchase more shares. When opting for reinvestment, the investor triggers the start of a process Albert Einstein called “the eighth wonder of the world”: the miracle effect of compounding interest. Compound interest, simply put, is interest on interest and it can help an investment grow at a faster rate. Accordingly, the value of this compounding increases over time.
Let’s look at a hypothetical example that shows how an investor’s decision to participate in an investment’s reinvestment program can significantly impact the long-term value of their investment. In this example, the results are depicted in Graph 2, we have three investors who invest $25,000 in the same investment but choose three different levels of participation in the investment’s (Dividend Reinvestment Plan (DRIP) program. Investor 1 decides not to participate in the program at all. Investors 2 decides to reinvest 50%, while Investor 3 chooses to reinvest 100% of their distributions back into their investment.
As we can clearly see in Graph 1, the value of each investors’ portfolio appreciates at a different rate, with Investor 3’s investment growing the fastest and Investor 1’s growing the slowest.
Notes: Example assumes a 5% annual dividend payout and a 9.3% annual growth rate for the underlying investment. The growth rate is based on the average return realized by the MSCI/IPD Canada Property Index from 1987 to 2016.
Remember, all three Investors purchased the same investment; the only difference is the degree to which they reinvested their distributions back into their investment. By the end of ten years Investor 3’s investment would be worth 28% more than Investor 2’s and 64% more than Investor 1’s investment.
So, the next time you are making an investment and have to decide whether to reinvest your dividends by participating in the product’s DRIP program, remember that the power of compounding can and will have a significant impact on the long-term value of your investment.