Compounding and planning

Shrewd investors use compounding to make sure all their money works for them. Combine that with a sound plan, and you’re well on the way to success.

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Make compounding returns work for you

Nothing is certain in life — least of all investing in the stock market. True, Canadian stocks in general nearly doubled in value from the depth of the COVID setback in March 2020 to March of this year before giving back about eight per cent in recent trading. But prudent investors know that achieving long-term success is trickier. It helps if you give yourself any edge you can at the start.

Re-investing all your dividends and interest is one such edge. It lets you make use of the magic of compounding: if you re-invest all your dividends or interest, it seems simple to become a millionaire — at least on paper. Just take $1,000 and double it ten times and you have $1,024,000. Unfortunately, there’s more to it than that.

Even at the best of times, taxes and inflation — even when the rate of inflation is low as it was a couple of years ago — may impede your progress toward becoming wealthy (by whittling down your investments). What’s more, you always have to consider the possibility of illness or unemployment or that the cash needs of your business or family may drain your investments.

Then too, a recession, a war or a revolution could obliterate any chance of making real progress with your investments.

Start with a sound plan

However, you can counter many, though obviously not all, of these obstacles to your investment success by devising a sound financial plan.

What are some of the priorities of a prudent financial plan? Assuming your income is sufficient to meet your daily, monthly and yearly needs (food, rent or mortgage, transportation and so on), you should set up two kinds of reserve funds.

Use the first to defray foreseeable expenses that may arise from time to time (buying a new car every decade or so, for instance). The other should serve as a contingency amount to cover any unforeseen expenses (illness or a prolonged layoff, for instance). One rule of thumb is that this emergency fund should be able to cover three to six months of your daily living expenses.

Your next concern should be to build up tax-sheltered savings by contributing to registered plans such as a Registered Retirement Savings Plan, or RRSP. Once you’ve established your reserves and set up your tax shelters, you should consider other investments.

As for non-tax-sheltered investments, you should diversify your holdings so as not to be too dependent on any one investment area. Stocks, stamps, coins, antiques, art, real estate and many others may all have a place in your portfolio.

Consider this

Now with a plan, and logical priorities, you can make the magic of compounding work for you. There are still a few points to consider, however.

It’s true that the higher the rate of return on your investments, the less time it takes to double their value. What’s more, increasing your rate of return only a few percentage points can make a big difference to your long-term investment results. For instance, if you invest $1,000 at five per cent, and leave it to compound for 45 years, you end up with $8,985. If, however, you invest at eight per cent, you end up with $31,920 after 45 years, more than three times as much.

But the more you expect from your investments, the greater your risks will be — and the greater your chances of suffering at least some big losses along the way.

Such losses can make a big difference to your investment results. After all, it only takes one 50-per-cent loss to wipe out the benefits of two successive 40-per-cent gains.

You can do better in the long run then, if you set your sights lower and aim for a steady rate of return on your investment over the years.

This is an edited version of an article that was originally published for subscribers in the June 3, 2022 issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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