The magic of compounding

• What is compound interest?
• Why compounding is so important to successful investing.
• How high fees can reduce the gains from compound interest.

Einstein (yes, that Einstein) is said to have called compound interest the "eighth wonder of the world". Pretty high praise from a man considered one of the world’s greatest thinkers. He reportedly went on to say, “he who understands it, earns it; he who doesn’t, pays it.” Whether or not these words are from Einstein himself, they hold much wisdom. So, let’s get down to understanding compound interest.

Interest comes in two flavours: simple and compound. If simple interest is a good thing, compound interest is even better because it helps you grow your money even faster. With simple interest, the amount you receive is calculated as a percentage of your original deposit. With compound interest, it’s calculated as a percentage of your original deposit plus all accumulated interest. So the interest earns interest. Then the interest on the interest also earns interest, and so on. It’s one big bundle of earnings.

This difference between simple and compound interest is huge. Check out this table that compares the two:

In just three years, the compounded interest puts an extra $76.25 in your account, without having to do anything.

That may not seem like a big deal, but take a look at what happens over a longer time frame:

What amounts to less than a hundred dollars’ difference after three years grows dramatically over two decades. Simply by allowing the interest to compound, you would've earned an additional $6,532.98. Not too shabby!

Wondering how long it takes to double any investment with compounded returns?

Explore our article about the rule of 72.

If compound interest is like growth hormones for your money, paying high fees is like putting your money on a starvation diet. When management fees are deducted from your account, they act like kryptonite and sap the superpowers of compounding returns.

Successful investors know that you need to do everything you can to maximize returns. But if you’re paying high management fees, it’s like trying to catch rainwater in a bucket with a hole in it. It doesn’t matter where you stand or how hard it rains, the water leaks out of the bottom.

Imagine this: say you were earning 5% like in our table above, but had to hypothetically pay management fees of 2.25%. Now your 5% return is really only 2.75% — and you have just over half the earnings to compound.

Some people resign themselves to the fact that management fees “are what they are,” as the saying goes. But there are alternatives.

One easy option is to invest in Questwealth Portfolios. These portfolios are designed by our portfolio managers and hold a globally diversified selection of ETFs. They are actively managed by experts who watch the markets and make adjustments when necessary to keep each portfolio balanced and aligned with its goals. Because the portfolios hold ETFs, you’ll enjoy ultra-low fees so more of your money benefits from compounded earnings over time.

So, when you’re evaluating investments, think of that compound interest quote. Don’t be the person who doesn’t understand compounding and ends up paying. Instead, be the one who does understand compounding and earns compounding returns.

Past performance is not necessarily indicative of future returns.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.