Education: Growth & Income Investing

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The Power of Compounding: Reinvest Your Interest

Growth & income investors are frequently described as exhibiting a buy-and-hold approach to investing. However, as I mentioned in my article, “Is Buy and Hold Dead?” investors in this camp need to stay on top of their portfolio. Sometimes holding on for the long term can be to your detriment. However, for those that pick long-term winners, they will see the value of their investments increase exponentially over time. This process is commonly referred to as the power of compounding.

Time Is Your Ally

Time can serve as a long-term investor’s best friend. If you manage to pick a long-term winner, and you have time on your side to invest, the longer your investment can compound, or increase in value.

Compounding can simply be defined as interest earning interest. Why is this so powerful? Because when your initial investment generates earnings, which are subsequently reinvested, a larger base is formed on which future earnings may accumulate. As your investment base gets larger, it has the potential to grow faster. This snowball affect can be amazing over the long term.

You can see how important this concept is when it comes to saving for long-term goals such as retirement. Suppose you decide to invest $10,000 into a hypothetical stock that returns 8% on an annual basis. At the end of the first year, you will earn $800 on your initial investment, now giving you a total of $10,800. If you let those earnings run, rather than spend them, another $864, or 8% of $10,800 will be earned in year two. You now have a total of $11,664 and the snowball keeps growing. This may not seem like a lot but after 20 years, your total wealth would be $46,610. After 40 years, it would be $217,245.

The earlier you start the investment process, the more money you have to invest, and the higher the interest rate, the faster your wealth will grow. Stocks in solid industries can serve as your best long-term investment vehicles. Growth and income stocks fit the mold perfectly.

Compounding with Growth & Income Stocks

Growth and Income investors seek quality companies that should outperform the market over the long haul, while limiting downside risk. Companies with consistent earnings growth, healthy balance sheets, quality products and services and an experienced management team typically do the job. These companies are usually larger in size (market capitalization), and while they do not typically crush the market on a total return basis, they should prove to be steady performers. And as you know, slow and steady performs quite well in the compounding race.

Furthermore, the dividends that growth and income stocks pay to shareholders only serve to enhance the power of compounding—if they are reinvested. Instead of taking your dividends in the form of cash, you should see if it is possible to plug that money back into the company and buy additional shares. Programs of this nature are called dividend reinvestment plans. They can be very beneficial over the long term and are worth the investigation.

Of course, you will be out of the compounding game, sitting on the sidelines, if you have chosen poor performers. Stocks with a Zacks Rank of 1 (Strong Buy), 2 (Buy) or 3 (Hold) should keep you in the game. However, when the Zacks Rank slips to a 4 (Sell) or a 5 (Strong Sell), your stocks will be given a healthy dose of kryptonite—draining their power to compound.

Rule of 72

Depending on the source, Albert Einstein referred to compounding as the eighth wonder of the world, the human race's greatest invention or the most powerful force of the universe. Moreover, Einstein is credited with discovering the Rule of 72.

A simple way to figure out the impact of compounding is illustrated by the Rule of 72. The Rule of 72 helps investors determine how long it will take for their investment to double, taking compounding into consideration. One simply needs to divide 72 by the return you expect your investment to produce. For example, if you expect your investment portfolio to return 6%, your funds will double in 12 years (72 divided by 6). Pretty cool, huh?