The power of compounding in stock investments

The principle of compounding extends beyond just financial investments; it can be applied to various aspects of life, illustrating how small, consistent actions can lead to significant long-term benefits. Here’s how the power of compounding works in different areas: personality development, habit formation, goal achievement, relationships, and investing in knowledge.

To achieve a huge compounding impact in all these areas, it is crucial to consistently practice them daily and make a habit out of it. The effort we put in today can lead to significant rewards in the future. By recognising this principle in various facets of life, we can employ its potential to create meaningful change and enhance our journey toward achieving our goals.

When it comes to investing, few concepts are as powerful and transformative as compounding. This principle can significantly impact your financial future, especially when you start investing early. When discussing the power of compounding, one of the first examples that pops to mind is Warren Buffett.

He started investing at the age of 11. You might wonder – what difference does it make whether he started investing at 11, 15, or even 20? This early start gave Buffett a significant advantage, allowing his investments to compound over many decades.

To demonstrate this, let's delve into Buffett's journey with some numbers. Imagine Buffett started investing $1,000 at age 11, with an average annual return of 10 per cent. This investment would have grown by 2.5 times by age 20. By age 50, that initial $1,000 would have ballooned to 140 times its original amount, and by age 90, that $1,000 investment would have grown to an astonishing $54 million, due to the remarkable effects of compounding.

Now, consider if Buffett had started investing at age 20 instead. That same $1,000, starting at 20 with a 10 per cent annual return, would grow to around $7.3 million by age 90. While still impressive, it's a far cry from the $54 million achieved by starting nine years earlier.

Compounding occurs when the returns on your investments begin to generate their own returns. In simple terms, it’s the process of earning interest on your interest, which can lead to exponential growth over time. To benefit from the power of compounding in your investments, it's crucial to focus on selecting high-quality stocks with the potential for steady growth and reinvest all earnings to maximise returns.

Adopt a disciplined approach by consistently investing a fixed amount regularly, regardless of market conditions. Adopt a long-term perspective, understanding that short-term market fluctuations are less important than the sustained growth over years and decades. Patience is key, as the true power of compounding unfolds over time. Avoid frequent trading, as it can erode returns through fees and taxes. Instead, let your investments grow undisturbed, allowing compounding to work its magic.

The key elements driving the power of compounding are time and the reinvestment of earnings. The longer your investments are allowed to grow, the more pronounced the compounding effect becomes.

(The writer is Group CEO, MarketsMojo)