One of the most powerful concepts in personal finance and financial planning is compounding.

What is compounding?

Put simply, compounding is the process where earnings on your investments, such as interest or returns, are reinvested to generate additional earnings.

It means your money grows faster over time as you keep reinvesting what you’ve earned.

Few people fully appreciate the impact that compounding can have on long-term wealth creation. Ultimately, if utilised well, compounding can play a key role in building a passive income stream that can replace your income when it is time to drop back from work or retire.

The power of time

The longer your money stays invested, the more it can grow. Time is the critical factor that maximises the benefits of compounding.

With this in mind, the #1 thing you can do to maximise the power of compounding is to get started now. The earlier you start investing, the more time your investments have to grow and compound. In addition to starting now, another key priority when trying to maximise the impact of compounding is to avoid interruptions to compounding where possible.

The snowball effect of compounding is what makes it so powerful, especially when you are investing for the long term, or for long term goals such as retirement.

Even small, regular contributions made early can grow substantially over the years. Starting early essentially means that you have to save less over the course of your life, as compounding will do more of the heaving lifting for you.

Let’s compare two scenarios – Starting early is key

To illustrate the power of compounding, these two scenarios may be useful.

• Person A starts investing $5,000 annually at age 25, and continues until age 35, then stops contributing but leaves the investment to grow until retirement at age 65.
• Person B starts investing $5,000 annually at age 35, and continues until age 65, contributing for 30 years.

Assuming an annual return of 7%, by age 65:

• Person A’s investment would be worth $602,000
• Person B’s investment would be worth $540,000

Therefore, despite the fact that Person A invested for only 10 years (total investment $50,000), compared to Person B for 30 years (total investment $150,000), their investment would be greater at age 65, purely thanks to the power of compounding.

It is not just about how much you invest, but when you invest, that matters. The earlier you start, the more powerful the compounding effect becomes.

But it is never too late

If you are reading this and feeling like you’ve missed the boat, it’s important to know that it’s never too late to start benefiting from the power of compounding.

While starting earlier certainly gives more time for growth, even beginning later, at say age 50, can make a meaningful difference to your financial future.

An adviser can of course provide you with a strategy to best make up for lost time, which may include more substantial contributions, a focus on growth-oriented investments, or taking advantage of superannuation catch-up opportunities.

The key is to start now, stay the course, be consistent, and make the most of the opportunities that exist.

The role of compounding in generating passive income

One of the key goals of long-term investing is typically to build a portfolio that can eventually generate passive income.

This passive income can then provide ongoing income to reduce your reliance on work when it is time to either scale back from work or retire altogether.

Compounding tips

Compounding can of course significantly increase your passive income stream in the long term, particularly as you approach retirement or a pull back from work as life progresses.

Here are a few tips to keep in mind to ensure you can get the most benefit from compounding:

• Stay invested for the long term: The longer your money is invested, the more compounding can work its magic. Try to avoid pulling out of investments prematurely, especially after markets have already declined. Time in the market is more important than timing the market.
• Diversification is key: Building passive income is not about relying on one source. A diversified portfolio of assets will help to manage risk and ensure your investments are best placed to perform as a whole.
• Start early, stay consistent: The power of compounding is available to anyone who invests early and stays consistent. Even a little bit invested early and regularly will go a long way. It is important to set realistic goals, focus on the long term, and resist the urge to chase short-term gains. Compounding will reward patience and persistence.
• Minimise fees and taxes, all of which potentially eat into your compounded returns.

Compounding is a very powerful tool in wealth accumulation. By starting early, staying the course, and letting compounding work for you, you can build wealth and create a passive income stream to support your financial independence in the long term.

If you would like to better understand the role of compounding in the context of your own financial plan and long-term financial goals, please don’t hesitate to reach out to our team – one of our Advisers would be very happy to discuss your situation.

Any information in this article is general in nature and does not consider any of your personal objectives, financial situation and needs. It is as intended, to be of a general nature only and NOT a recommendation to you. You should consider whether the information is appropriate to your needs, and where appropriate, seek personal advice from a registered financial adviser.