The effect of compounding interest was called by Albert Einstein the 9th world wonder. So therefor it must be very special and important for investors we suppose.
What do we mean with the compounding effect? The compounding effect is the effect of growing by small amounts at first but later accelerating very fast. What his to do with financial markets you wonder?
We see this effect with dividend returns. When you receive a dividend each year and you re-invest the dividend directly into new shares of the same company you will see your total position in that stock slowly growing. When you receive a dividend in stocks of let’s say 3 percent of a stock (which means you receive 3 euro dividend of a stock that is trading at 100 euros) then you have 3% more of that stock. So you grow from 100 to 103 if you have one share. The next year you might again receive 3 percent of that 103 euros. So then you receive a little more than in the previous year. By doing this each year you receive more and more dividends.
This effect of re-investing each year a little bit more is called an exponential effect. We see this effect in the bond market where you normally receive coupons periodically and in the stock market by receiving dividends.
But unfortunately , or ofcourse, this is no free lunch. This compounding effect sounds like an excellent investment strategy but in practice it will take a very long time to see this effect in your portfolio.
After only a very long time we see this exponential effect occurring. For almost every investor in the world these kind of extreme long holding periods are far from realistic. So when people talk about high yielding dividend funds one must be very alert as many investment companies use this compounding effect as a marketing tool.
Of course we see the same effect when you put your money on your bank account. When you re-invest the received interest each year you can see the same exponential effect, but only after a very long time.
Video done by Tim van Thienen and Denise Lindemann.