Albert Einstein called compound interest “the greatest mathematical discovery of all time”. I totally agree with him. And when it comes to property investing, I also like to refer to compound return as “the eight wonder of the world”. Compounding is like dynamite to a property portfolio where capital growth gets stronger and stronger as more and more time passes. Time being the operative word!
Unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.
The wonder of compounding (sometimes called “compound interest”) transforms your working money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating earnings on an asset’s reinvested earnings. To work, it requires two things: the re-investment of earnings and time. Time being the key ingredient particularly when it comes to creating wealth through property investing.
The more time you give your property investments, the more equity and wealth you create and the more you are able to accelerate the income potential of your original investment.
To demonstrate, let’s look at a simple example using a $10,000 investment:
If you invest $10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now let’s say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236 ($10,600 x 1.06) by the end of the second year.
Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but let’s not forget that you didn’t have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. After the next year, your investment will be worth $11,910 ($11,236 x 1.06). This time you earned $674, which is $74 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest.
If you’ve been following my blogs, you’ll know the importance of time when it comes to property investing. Time is the secret ingredient to create more wealth through property as the longer you hold onto a quality investment property, the greater appreciation in value over time.
Asset selection is also very important. I have seen many situations where holding onto the wrong investment property can work against you if capital growth is modest (or none) as you incur opportunity cost; i.e. the cost of not taking action as you wait with the hope that your investment has it’s day in the sun one day!
There are several implications for investors looking to take advantage of the power of compound returns.
First, if you can take a long term approach, focus on growth assets like property with a long term track record.
Second, start contributing to your investment portfolio as much as you can as early as possible. The earlier you start, the more equity your portfolio will create over time.
Third, when it comes to property investing always have financial buffers in place. Understand that the investment cycle is a normal part of any investment and partly explains why growth assets have a higher return in the first place. If your property investment is going through a period of downturn, don’t panic and use your financial buffers to ride the ups and downs that comes with property investing. Over the long term, you’ll be glad you did.
Statistics suggest that 95% of property investors will sell a property as soon as they see a profit on the table, which is usually within a few years from purchase (particularly in a rising market).
Warren Buffet once said “our favourite holding period is forever”. This is the reason why Warren Buffet is the most successful investor of our time and the world’s richest, simply because he’s old.