The power of compounding

Compounding works best the longer the investment timeframe.

Compounding is a well-publicised concept in investment. Essentially, it refers to the returns that an investor gets when he reinvests his earnings each year. 

Albert Einstein was said to have referred to compounding as the eighth wonder of the world. The power of compounding is also well illustrated by Warren Buffett's own investment journey. Despite starting his investment journey at the ripe age of eleven, 99 per cent of Buffett's wealth was earned after his fiftieth birthday.

HOW YOU CAN COMPOUND YOUR WEALTH

So how can the retail investors compound wealth over time?

Ser Jing and I have formed a list of criteria that can help us find stocks that can compound meaningfully over the long term.

For instance, one of the characteristics we look out for is companies that operate in an industry that is growing. These companies tend to grow along with the industry. But that's not all. We also want to pinpoint companies that can capitalise on the growing market, whilst increasing their market share at the same time.

Take Amazon.com for example. Well before the company reached its current size, shrewd investors could have identified Amazon as the next big thing. Jeff Bezos was a visionary entrepreneur who was focused on customer satisfaction.

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He realised the importance of a great customer experience, which enabled Amazon to dominate the growing e-commerce space. The signs back then were telling.

Even if you had bought in at the peak of the dot com boom, you would have made a 16 per cent annualised return over 20 years. That's a 2000 per cent gain in just 20 years.

In addition, we also look for disruptors who can win market share in an already large industry or even create a whole new market on its own.

For instance, in the past customer relations management was not a big industry nor did companies truly identify it as a problem that needed solving. However, software such as salesforce has completed changed the way companies manage their customer relations.

Nowadays, many companies cannot go a day without a customer relations tool. It has become an important software in some of the largest companies in the States.

Although much more prominent now, Salesforce is still small in relation to the potential addressable global market.

TIME IS YOUR FRIEND

Compounding is certainly a powerful investing concept. But, perhaps the biggest takeaway of all of this is that compounding works best the longer it is allowed to grow. Consider the example below.

If you have an investing life span of twenty years and are able to compound your wealth at 10 per cent per year, your eventual returns will be 570 per cent at the end of the investment cycle. Not too shabby.

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However, by adding just another five years to the investment time frame, you would have made a 980 per cent return, 410 per cent more in the extra five years. As you can see, time is indeed your friend when it comes to investing.

If you are thinking of investing but have not started yet, remember that the earlier you start, the more rewards you will reap in the future.

Hopefully, this post encourages readers to start their investment journey as soon as possible. With that, Happy compounding and invest on!

This article was first published on The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.