Everyone would love to invest when equity prices are low and sell when prices are high; that would be ideal. This notion of buying low and selling high is known as “timing the market”. However, more often than not, investors that attempt to do so miss out by remaining uninvested for too long as they sit on the sidelines and wait for prices to drop before they invest again. During that time, not only do they miss out from possible advances in prices but more importantly from the benefits of compound interest.
So what is compound interest?
To understand compound interest, you first need to understand simple interest.
Simple interest is the interest you will receive only on the initial amount you invested i.e.
- You invest €100,000 for five years and you earn 5% simple interest every year.
- Every year you withdraw the €5,000 interest you earn.
- By the end of these five years, you will receive back your initial €100,000 plus interest of €25,000 (= 5% interest x €100,000 principle x 5 years). This is a total return (cumulative return) of 25%.
Compound interest on the other hand, is the interest you will receive on the initial amount you invested plus the amount of interest payments you have already earned. i.e.
- You invest €100,000 for five years and earn 5% compounded interest every year, without withdrawing aby interest that you have earned.
- In Year 1 you earn €5,000 worth of interest which is equal to 5% interest on €100,000
- In Year 2 you earn €5,250 which is equal to 5% interest on €105,000 (= €100,000 principle + €5,000 interest earned on Year 1)
- In Year 3 you earn €5,513 which is equal to 5% interest on €110,250 (= €100,000 principle + €5,000 interest earned on Year 1 + €5,250 interest earned on Year 2),
- …and so on and so on
In the first example you earned 25% cumulative return, while in the second example you earned 27.63%. The difference becomes even more pronounced when we extent this to a 10-year investment period…with simple interest you would have generated 50% while with compound interest you would have generated 62.9%!
More specifically, in the equity markets returns are compounded daily, which explains the 234.4% total return the S&P 500 index* has generated over the 10-year period presented below – whereas with simple return the performance would have been only 139.8%.
As you can see the benefits of compounding returns are enhanced the longer you are invested in the market.
* The above should only be used as an example. Past performance is no guarantee of future performance. Investment return and principal value may go down as well as up and could result in a significant loss of the capital invested