The American economy is defined by compound returns.
At one end of the spectrum, most of the U.S. retirement system now depends on individual 401(k) accounts. Workers invest and re-invest over the course of their careers, eventually cashing out when they stop working. The way that $100 per week turns into a healthy retirement account is the magic of compounding returns.
On the other end of the spectrum, compound interest defines the life and finances of almost half of young Americans. Student loan debt exceeds credit cards and auto loans, most of it held by millennials. Thanks to higher average interest rates than what banks charge for houses and cars, the odds of young people buying those homes and vehicles get longer every year.
Compound returns, in other words, are a powerful thing. The good news is that you can put them to work in your own portfolio.
What Are Compound Returns?
Compound returns is when the value of your investment grows based not only on the original principal but also based on the returns that investment generated.
For example, say you put $1,000 into an investment with a 10% annual compound interest. At the end of the first year you would have $1,100; the original money you put in, plus your 10% return of $100.
At the end of the second year you would have $1,210. At the end of the third year you would have $1,331, and $1,464 by the end of the fourth, and $1,610 by the end of the fifth. Your account grew by more than $100 each year because each year's interest rate was compound. It applied to the full value of the account, meaning both the principal and its gains. So in your second year, you earned 10% of $1,000, in the third you earned 10% of $1,210, and so on.
The mechanics of compound returns are relatively simple. In an ordinary income-generating investment, when your investment generates income the holder of that investment sends you a check. For example, when a bond pays interest it might send you a check for the value of that interest rate.
A compound return investment also generates income. However, unlike an ordinary product, in this case the holder of that investment takes the income it generates and adds it to your principal. Then, the next time your return on that investment is calculated, they use the new value of your account as the basis for the calculation. This process repeats itself every time the asset generates a return. (So, if you are paid quarterly, the firm re-invests your income and recalculates it four times per year, if paid annually they do so once a year, and so on.)
What Is the Value of Compound Returns?
Compound returns are generally seen as one of the most valuable investment forms, and most expensive forms of debt, in all of finance. They're so important that people attribute an apocryphal quote to Einstein calling compound interest the most powerful force in the universe.
Take our above example again. We have put $1,000 into an account bearing 10% interest. Let's say it's part of a retirement scheme, so we leave it alone for 40 years. At 65, when we pull out that money we set aside in our mid-20s, it will have grown to more than $45,000. Our example is also rather unrealistic. It's far more likely that this investment would compound quarterly, leading to a final value just shy of $52,000.
A single impulsive investment at age 25 can now provide an entire year's income in our retirement.
For long term investors, compound returns can give you some of the best investments in the market. They are often not incredibly valuable in the short term. Compound return investments will often not provide the kind of speculative gains that an explosive stock could give, for example. But over a course of years, compound investments can post significant growth because the value of that investment adds (literally compounds) upon itself.
How Products Offer Compound Returns
To offer compound returns an asset needs to meet a few basic requirements:
- The investment must pay returns to the holder of the asset in the form of dividends, interest or another income stream. It cannot be an asset whose value is only realized once you sell it.
- The investment must take those returns and reinvest them in the underlying principal used to calculate your gains.
Now, financial products can do this in two main ways:
- Interest payments - This is the example we have used in this article. The investment has a fixed rate of return calculated based on the underlying principal, and all gains are added to this underlying principal to increase the rate of return.
- Asset holdings - The investment is based on a collection of assets, for example a stock portfolio, and it gains its value from any income generated by those holdings. All gains are used to buy more assets, thereby increasing the number of holdings which can generate income on an ongoing basis.
Common Products for Compound Returns
Several forms of investment products offer compound returns. Some of the most common include:
Mutual Funds - Many mutual funds offer compound returns. The most common format here is for the fund to invest in stocks which pay dividends. It then uses those dividends to buy more shares of stock, so that during the following cycle you will receive more dividends (since you hold more shares).
Exchange Traded Funds (ETFs) - Compound return ETFs are also common. Like mutual funds, they typically operate by investing in dividend-paying stocks. The fund then takes each shareholder's dividends and, instead of sending a check, buys you more shares of stock. The next time the stock pays its shareholders, you receive a larger dividend check which the ETF reinvests again.
Certificates of Deposit - A CD is an investment asset issued by a bank. Compound interest certificates of deposit pay a fixed rate of interest, compounded on a scheduled rate, with a set date of maturity. It operates exactly as our example above. Every time the CD issues an interest payment the bank automatically adds that payment to the underlying principal. At the CD's maturity, you receive the entire amount.
Zero-Coupon Bonds - These are structured slightly oddly. A zero-coupon bond is a bond which pays compound interest, with the rate of interest, schedule and date of repayment all fixed. The face value of the bond is what it will be worth upon maturity. When you purchase the bond you pay the bond's value today, so what that face value is worth when reduced by its interest and rate of compounding.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription toTheStreet's Retirement Dailyto learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? EmailRobert.Powell@TheStreet.com.