Every investor wishes to find the Holy Grail of investing to become wealthy, but would be disappointed to find out there isn’t one.
History has shown that an investment in equities over the long-term allows an investor to grow and compound his money. There is, however, no magic formula or shortcut involved – the process requires patience and psychological fortitude over time. This article will focus on two main methods of compounding wealth, as described below.
Compounding Through Business Growth
By investing our capital into companies with strong business models and a long runway for growth, we can compound and grow our wealth as these companies go on to increase their profits, cash flows and dividends over many years to come.
The key, of course, is to search for the right companies to park our capital, as some companies may fall prey to technological disruption or succumb to competitive threats and fall by the wayside. This may seem tricky, but this is where the investor has to do proper due diligence and exercise good judgement in his selection. It’s also important to trim the portfolio periodically to remove under-performing investments.
Compounding Through Dividend Reinvestment
Another method of compounding is to reinvest the dividends we receive from the companies we invest in over the years. This would, in turn, generate even more dividends which will be continually ploughed back into the market, thus generating a positive feedback loop.
A simple example to illustrate this is as follows: An investment of $100 in a company yields a 5% dividend ($5). The investor then reinvests this dividend to purchase shares in the same company, thereby increasing his investment to $105. The next round of dividend he would receive is now 5% of $105 or $5.25. Assuming a consistent injection of capital to grow one’s investment portfolio base, as well as constant reinvestment of dividends received, one’s portfolio would grow to a significant size after many years. The compounding effect is shown in this article here.
The Foolish Bottom Line
In both cases described above, an investor has to follow a consistent process of reinvesting his dividends, as well as checking on the fundamentals of the companies within his portfolio. Compounding is described as the “eighth wonder of the world” by Albert Einstein, and is one of the magical forces in investing which can make one wealthy, but it does require patience, fortitude and an ability to tolerate sharp share prices swings.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.