People are not aware of finance’s most important law: capital compounding effect. Interests generate interests and thus, capital grows exponentially, not linearly. Why is this so important? Just because very little annual return makes a huge difference over the long-term. The main example is when you reinvest the dividends received from your stocks. If you buy shares with this cash received as dividends in the same stock, although the annual return obtained would be the same, the growth of your capital would be exponential, rather than linear.People are not aware of finance’s most important law: capital compounding effect. Interests generate interests and thus, capital grows exponentially, not linearly. Why is this so important? Just because very little annual return makes a huge difference over the long-term. The main example is when you reinvest the dividends received from your stocks. If you buy shares with this cash received as dividends in the same stock, although the annual return obtained would be the same, the growth of your capital would be exponential, rather than linear.

As an example, let’s imagine two financial products. The two of them give a 10% annual return. Yet, one of them (Product 1) reinvests annually, which means that the interests obtained are accumulated to the capital. Product 2 gives the same return, but this money is converted into cash and saved in the wallet. Product 1 is subject to the compounding law while Product 2 is not. Initial investment is in both cases €100,000. What would be the capital after 5 years in each case?

As we can see, after 5 years, with Product 1, the investor would have €161,051, while with Product 2, the investor would have €150,000, The difference is that this 10% return is on notional value, not on the total value of capital. So that, if interests are not reinvested, capital grows, but notional value does not, so effective interest rate on total capital is decreasing each year.

But, how does this effect of compounding affects in the long-term? Mathematically, Product 1 grows exponentially while Product 2 grows linearly. Thus, the further in time, the larger the difference, as we can see in the next 30 years graph:

After this period, the difference between having invested in one product or the other is more than €1.3 million. As we can see, the capital of Product 1 has a growing slope, whereas in Product 2 the slop is constant, meaning that each year, the amount added to the capital is larger in Product 1 and constant in Product 2.

The conclusion, then, is that, in the long-term, compounding effect is quite relevant, and the only way to create wealth is applying saving-investment strategies according to this financial law.

Yet, it is not the only implication. The law of compound interest requires us to invest in fiscally efficient products. The effect of this tax saving makes a different in a wide period of time since that amount not paid each year in taxes is compounded and creates wealth exponentially. Let’s imagine two investment products, Product 3 and Product 4. The first is tax efficient (i.e. you don’t pay taxes on profits each year), while Product 4 is not tax efficient (i.e. you pay taxes on profits each year). Both products are compounding (as Product 1 in the previous example), and the tax rate is 20% (on gains). With Product 3 you pay taxes when you finally withdraw our money. Let’s assume that an individual invests for 5 years. The result is as follows:

The first year, Product 3 obtains on a net basis a 10% return, while Product 4 obtains a 10% gross less 20% tax, that is, 8% net return. The process is equal until last year. In year 5, before the investor withdraws the money, he has more money in Product 3, which has not paid any taxes, but now he must pay a 20% on total profit, which is 61,051. This tax payment is 12,210, so the net capital at year 5 is 148,841, slightly higher than in Product 4. So that, we can prove that tax efficient products give higher return than non-fiscal efficient ones.

The reason for this statement is that tax savings (in year 1 would be €2,000, for example) are subject to the compounding effect, so in the long-term grow exponentially. So, with a far time horizon, this effect is more notable.

As we can see, both products grow exponentially, so the compounding effect applies, but one grows more than the other. This makes a difference in the long-term, as we said before. The gap after 30 years of investment, considering the tax on total profit in Product 3 (which explains the fall in capital in this product last year) is larger than €400,000. So that, even if you have to pay taxes, the effect is positive if you can postpone it until the end of the investment period.

In summary, knowing the magic of compound interest is an essential factor to achieve successful returns for any investor. With very little capital, you can make a lot of money by being patient and disciplined. Interests generate interests, and this repeated permanently allows wealth to increase exponentially. Applying this basic financial law to decision-making when choosing between investment alternatives is crucial to obtain above-the-average net returns on capital.

*You can download the Excel spreadsheet with graphs and tables here: Annual compounding spreadsheet. I suggest you to change data and prove with different numbers and periods just to make an idea of the relevance of the compounding effect.*

Pingback: Fundsmith: Robust portfolio, robust performance and robust investment philosophy | Market Inefficiencies

Pingback: Viscofan: An Example of Value Creation | Market Inefficiencies

Pingback: 18 Principios sobre Libertad Financiera

Pingback: 18 Financial Independence Commandments | Market Inefficiencies