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The Beauty of Compounding And How It Can Make You Rich

Compounding is a beautiful thing, if investors are patient enough to obtain it.

In essence, compounding refers to the ability of an asset to generate more earnings from its previous earnings. For example, if you receive a 7% yield on a S$1,000 investment, you would have received S$70 in dividends. If you reinvest that S$70 into the same shares with a 7% yield, your investment amount will increase to S$1,070 — and you will be eligible to receive S$74.90 in dividends the following year.

If you stretch that out to 10 years, your investment would have nearly doubled to S$1,967. In 20 years, that number would have risen to S$3,869 and in 30 years, S$7,612. That’s the powerful effect of compounding.

Albert Einstein is believed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it. Compound interest is the most powerful force in the world.”

Increasing the frequency of compounding

That’s not all.

If the dividend paid more than once a year, your money can compound at even faster rate. In fact, that is the case for many REITs in Singapore, which often pay out a distribution every quarter instead of every year.

Let’s say a REIT in Singapore, at its current price, is offering an annual yield of 8% and pays its distribution out quarterly. That means that if you invest S$10,000 into the REIT, you should receive $200 each quarter, adding up to a total of S$800 over the course of the year.

But if you reinvest the dividend that you receive each quarter, you will be able to earn additional dividends on your reinvested dividends. In effect, the increased rate of reinvestment allows your investment to compound quarterly. If you factor in this affect, your investment will instead give you S$824.32 over the course of the year, which is more than S$800 received where there was no quarterly reinvestment. That may seem like a small difference but over a few years, you will have seen the effects add up substantially.

For every S$10,000 with an 8% dividend reinvested annually, after 30 years you will end up with S$100,626 over the course of 30 years. That’s not a bad return on your S$10,000 investment.

However, compounded quarterly, over the same time frame, you will have S$107,651. It may not seem that much difference in the grand scheme of things but is actually 70% of your initial outlay of S$10,000 or S$7,000 more than if you compound it annually.

Dividend reinvestment is key

The effects of compounding cannot be understated.

It enables you to generate higher returns without adding additional capital. That’s why if you have the means and are trying to build up your investment portfolio, you should always reinvest your dividends each time you receive it.

There are numerous companies in Singapore that offer dividend reinvestment schemes, enabling shareholders to purchase shares of the companies at a discounted rate with the dividends they receive. In return, companies use the dividend reinvestment scheme as a way to generate more cash in its business, which they can reinvest for growth.

The Foolish bottom line

The effects of compounding is more clearly seen as the number of years of investment grows. As such, starting early is essential. We should also try to ensure that we regularly reinvest our dividends so that we can compound our investments more regularly and make the most use of our money.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't owns shares in any companies mentioned.