If you are an investor, there is one important thing you need to know about compounding returns: they can make you more money. But how can investors receive these compounding returns?
Of course, after this, your only question may be, how can you receive compounding returns? Now, on the surface, compound returns is a relatively simple concept. This is because, in short, it is a way for you to earn interest on your interest as an investor.
As you can imagine, though, there is a bit more to actually receiving compounding returns. After all, this isn’t something that every investor manages to do. So, to learn more about how this process works, consider the information below:
The Benefits of Compounding Returns
Let’s first take a look at why you should make an effort to earn compound returns on your original investment. As mentioned, compounding returns allow you to make more money than you initially would have. This is because, with this form of investment, you reinvest the profits that you made.
Therefore, you end up investing more than you initially would, if you were simply pocketing the dividends. If this still sounds a little complicated, let’s break it down further. Let’s imagine that you have invested $10,000 and at the end of the year with a guarantee of a 10 percent interest rate per annum. At the end of the year, you are paid back a payout of $1000.
At this point, you have the option of either walking away with this profit or to put the money back into the same company. For the sake of understanding how compounding returns works, let’s say that you decide to invest this $1000 back in the company.
This means that in the first year as an investor, you invested $10,000 in the company and earned $1000 for this amount. However, by putting it back into the company, you are now investing $11,000 in the company and earning more on this higher amount. Therefore, at the end of the second year, your account will total $12,100. Investing in gold for example, won’t give you compounding returns.
To put this profit into perspective, let’s see what would happen if you decided to keep the profits of the first year for yourself. Then, by continuing with your investment of $10,000 you will have $12,000 once your second year of investment closes out. As you can see, compounding returns helps you to earn more profits.
Your Options for Compounding Returns
In this section, you will be introduced to how you can earn compounding returns on your investment. This can be done one of two ways – growth option or dividend reinvestment. The dividend reinvestment option works for both individual investors and mutual funds. Growth option, on the other hand, is typically reserved for those in mutual funds.
Dividend Reinvestment Plan
Many companies offer such plans, which are also known as DRIPs. Here, you have the option of either investing all, some, or none of the dividends that you have earned on your shares. If you do decide to reinvest, however, this money will be used to buy you a greater number of shares in the company. As such, your account grows at a faster rate.
As stated, mutual funds usually offer such a form of reinvestment to their investors. In this scenario, your dividends are automatically put back into the mutual fund. When this happens, the net asset value of the fund increases as a whole. In turn, the mutual fund is able to invest in more stocks. In this situation, the investor’s total number of shares don’t increase. Rather, their share of the fund is what rises in value.
As an investor, you should understand that there are tax implications for various forms of reinvestment. So, when deciding which option to select, you should determine how much it will cost you in the long run. After all, the goal here is to make as much money as you can, using one of the previously mentioned methods.
Are There Downsides to Compounding Returns?
Up to now, you may have heard of all of the advantages of compounding returns. However, as with anything else, there is also another side to this form of investment. So, let’s consider when you need to limit your reinvestment plan.
One of the biggest downsides of reinvestment for the sake of compound returns is that it prevents portfolio diversification. See, for an investor to be able to manage his or her risks properly, they need to spread out their investments. However, if you keep reinvesting all of the profits that you make into the same company, this can be difficult to do.
So, should you decide to join a DRIP, make it a point to reevaluate your position after a while. You may then determine that it is a better idea to only reinvest part of your dividends and then place the rest in other asset or asset classes.
How to Maximize Your Compound Returns
In this section you will find the most important tips to follow to make the most of your reinvestment plans:
- Start Early: you will realize that time is directly correlated to your compound returns. Therefore, the longer time that you have invested in a fund or a company, the greater the returns. This is why it is best to invest as early as possible. Then, your account is allowed to mature for longer, before you need to withdraw from it.
- Do the Math: when looking for a company or mutual fund to invest in, always compare interest rates. Keep in mind, a difference of just one percent can mean several thousand dollars and maybe even more down the line. Always look for the most amount that you can make given your investment limit
- Play the Long Game: with compound returns, the profits only really kick in several years later. Therefore, to make such an investment truly worth your while, you need to be patient about reinvesting your dividends back into the company.
These are the most important elements that you need to understand regarding compounding returns. Once you have grasped these concepts, it will become a lot simpler for you to determine which plan is most suitable for you. In turn, this will allow you to grow your initial investment with time.