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The magic of compounding

Posted by Massimo Satira November 8, 2019 • 5 min read

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  • What is compound interest?
  • Why compounding is so important to successful investing
  • How high fees can reduce the gains from compound interest
Ripples of a drop of water hitting a pond

You may have heard of “the magic of compound interest.” Although it’s not magic, compound interest does have an impressive ability to help you build wealth. But if you’re not careful, its wealth-building power can easily be reduced by high fees.

Now, we live in a world where the more we pay for a product or service, the more we typically get. But when it comes to investments, the opposite often holds true: the more you pay in fees, the less money you get to keep. So, let’s take a closer look at how compound interest works, the role of fees in successful investing, and how high fees can chip away at the gains you make from compound interest.

What is compound interest, exactly?

Einstein (yes, that Einstein) is said to have called compound interest the “eighth wonder of the world.” Pretty high praise from a man considered one of the world’s greatest thinkers. He reportedly went on to say, “he who understands it, earns it; he who doesn’t, pays it.” Whether or not these words are from Einstein himself, they hold much wisdom. So, let’s get down to understanding compound interest.

Interest comes in two flavours: simple and compound. If simple interest is a good thing, compound interest is even better because it helps you grow your money even faster. With simple interest, the amount you receive is calculated as a percentage of your original deposit. With compound interest, it’s calculated as a percentage of your original deposit plus all accumulated interest. So the interest earns interest. Then the interest on the interest also earns interest, and so on. It’s one big bundle of earnings.

Compounding adds dramatically to your earnings

This difference between simple and compound interest is huge. Check out this table that compares the two:

5% Simple Interest 5% Compound Interest
Initial deposit $10,000 $10,000
Balance after 1 year $10,500 $10,500
Balance after 2 year $11,000 $11,025
Balance after 3 year $11,500 $11,576.25
Total interest earned $1,500 $1,576.25

In just three years, the compounded interest puts an extra $76.25 in your account, without having to do anything.

That may not seem like a big deal, but take a look at what happens over a longer time frame:

5% Simple Interest 5% Compound Interest
Initial deposit $10,000 $10,000
Balance after 10 years $15,000 $16,288.95
Balance after 20 years $20,000 $26,532.98
Total interest earned $10,000 $16,532.98

What amounts to less than a hundred dollars’ difference after three years grows dramatically over two decades. Simply by allowing the interest to compound, you would've earned an additional $6,532.98. Not too shabby. (Wondering how long it takes to double any investment with compounded returns? Read our blog on the rule of 72.)

The key to successful investing

If compound interest is like growth hormones for your money, paying high fees is like putting your money on a starvation diet. When management fees are deducted from your account, they act like kryptonite and sap the superpowers of compounding returns.

Successful investors know that you need to do everything you can to maximize returns. But if you’re paying high management fees, it’s like trying to catch rainwater in a bucket with a hole in it. It doesn’t matter where you stand or how hard it rains, the water leaks out of the bottom.

Imagine this: say you were earning 5% like in our table above, but had to pay management fees of 2.25%. Now your 5% return is really only 2.75% — and you have just over half the earnings to compound.

To see how much of a difference fees can make to your bottom line, let’s take a close-up look at two balanced portfolios — one is a Mutual Fund portfolio, and one is a Questwealth ETF Portfolio containing Exchange Traded Funds. Both began with the same original deposit and hold comparable investments. But the Mutual Fund Portfolio fees are around 1.5% higher than the Questwealth Portfolio fees.

Now, that may not seem like very much. But take a look at what happens over time:

Compounding calculator

After 30 years, the Questwealth Portfolio, simply by paying around 1.5% less in fees, could be worth $75,276 more than the Mutual Fund portfolio, without any effort or any additional contributions. When it comes to fund fees, less really is more.

What are you paying for?

Some people resign themselves to the fact that management fees “are what they are,” as the saying goes. But there are alternatives.

One easy option is to invest in Questwealth Portfolios. These portfolios are designed by our portfolio managers and hold a globally diversified selection of ETFs. They are actively managed by experts who watch the markets and make adjustments when necessary to keep each portfolio balanced and aligned with its goals. Because the portfolios hold ETFs, you’ll enjoy ultra-low fees so more of your money benefits from compounded earnings over time.

So, when you’re evaluating investments, think of that compound interest quote. Don’t be the person who doesn’t understand compounding and ends up paying. Instead, be the one who does understand compounding and earns compounding returns.

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The information in this blog is for information purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied is made by Questrade, Inc., its affiliates or any other person to its accuracy.