What are compound returns?What are compound returns?

Let’s take a look at why this is the case, and how you can get the most value out of compound returns.

Starting simple

Let’s start with the basics: simple returns. These are exactly what they sound like—the percentage return you make on your investment. If you put $100 in a bank account that paid a 3% interest rate, you’d have received $3 at the end of the year. That $3 is your simple return. Easy.

Now that you have $3, you have a decision to make. You can leave your $3 in the bank, or you can take it out and use it—like to buy an ice cream. If you take your $3 out, then wait another year, you’ll have another $3 in interest at the end of year two. That interest comes from your original $100 deposit, earning $3 again. Sounds great!

Going compound

But what if you left the interest in the bank account instead? This would change things. You’d start the second year with $103 in the bank. At the end of the year, you would have $106.09, made up of:

• $100 that you deposited in the first place

• $3 in interest from the first year (3% of $100)

• $3 in interest from the second year (3% of $100)

• 9 cents in interest on the $3 you made in the first year (3% of $3).

That extra 9 cents is your compound interest! In other words—that’s interest on your interest.

Why it matters

Now you’re probably wondering why we’re getting excited about 9 cents. And fair enough. When you’re dealing with just $100 a year, you’re not going to get huge amounts of either simple or compound returns—but the principle is the same whether you’re investing $100, $1,000, or $10,000 a year. 

The key concept is that the 9 cents is interest on your interest. It’s not interest earned from your initial investment. And it was also just from the first two years. In the third year, you’ll earn interest on your initial deposit, plus interest on your interest, plus interest on the interest you earned in your second year. It’s interest on your interest on your interest!

It’s a bit like planting a garden. If you planted something from a seed, after a while you’d have a little plant. That plant would drop more seeds. If one of those seeds started growing, you’d then have two plants—each of which would drop more seeds. Then you’d have four plants, and four more seeds.

After a while, you could chop down the initial plant, and still have lots of new plants. 

Compound interest is the same principle. In fact, if you left your $100 in the bank at the same 3% interest rate for 30 years, you’d have $242 in total—including $142 in interest! That’s $90 in interest on your original $100, plus another $52 in compound interest! That’s 50% of your initial investment—so if you were investing more than $100, you’d start to see some really high-impact results. 

Compound returns

Compound returns are similar to compound interest, but not identical. The idea is that by leaving your money invested—or reinvesting any money your investment pays you over time—you could start to earn returns not just on your initial investment, but on any returns made along the way. This can happen a couple of ways …

Your investment goes up in value

Say you invested $100 in some shares, and after a year, the value went up by 10%. Now your investment is worth $110. If it goes up by another 10%, your investment value would be $121—because it’s 10% of your initial investment, plus the growth you enjoyed in the first year. Over time, this adds up. 

(It’s worth mentioning that constant 10% returns are rare—and not guaranteed. Any share can fail to gain (or lose) value.)

You reinvest your dividends

Let’s say you buy 100 shares for $1 each, and they pay dividends of 10 cents per share, per year. At the end of the year, you get $10 from your 100 shares.

If you spend that $10 on another 10 shares, you’ll now have 110 shares. When next year’s dividend day comes around, you’ll get $11, because you have 10 more shares than you had last year. Reinvest that, and now you have 121 shares. Next dividend day, the dividend is $12.10.

You can think of this process like a snowball turning into an avalanche. In the beginning, the differences are pretty small. But over time, as each year’s returns earn returns of their own, your total returns can really start to grow.

But there’s a big caveat here—the above example assumes the company's share price stays the same and it pays the same dividend each year. We’ve used this simplified example to explain how reinvesting dividends might result in compound returns. 

In real life, share prices and dividends are much less predictable:

• the share price might increase or decrease

• the company might not pay a frequent dividend (or any dividend) 

• just because a company paid a dividend one year, doesn’t mean it’ll pay a dividend the next

• the overall value of your investment could decrease (meaning you may not get compound returns on reinvested dividends). 

The importance of time

Many potential investors wonder ‘when is the best time to start investing?’ The answer that many hear is ‘yesterday’. This comes from the idea that time is critical for compounding returns.

By delaying starting, these potential investors are reducing the time available to them to reap the benefits of compounding returns. And while it’s never too late to start investing, starting early can certainly help.

Compound returns and dollar-cost averaging

We’ve spoken a lot about dollar-cost averaging in the past, which is when you invest a set amount on a regular basis. 

Dollar-cost averaging can make your compound returns even more powerful, because you’re giving your money more opportunities to earn returns over time. If the amount you invest is growing, then your opportunity to make returns grow too—and if your returns grow, the opportunity to make compound returns grows too.

Compound returns aren’t guaranteed

One big thing to remember is that compound returns—like all returns—aren’t guaranteed. Some snowballs stay snowballs forever, or they melt. Some seeds never turn into plants, and some plants get hit by frost before they get a chance to drop their seeds. 

It’s exactly the same with investing. Not all investments are going to give compound returns. That’s why we recommend diversifying investments, so that the impact of any one investment being unsuccessful is hopefully reduced. 

But if you do get compound returns, they can really pay over time. 

Get amongst it!

So now we know what compound returns are, and what the value can be in letting these grow over time. But don’t take our word for it. The best way to see the magic of compound returns is to investigate it for yourself. 

Take a look at MoneySmart’s calculator and run a few different scenarios. You’ll be amazed at how much of your long-term returns could be compound returns, and what a difference you might make by investing regularly with a long time horizon.