Finance 101 - Compounding

We have all been inundated over time with the message on the power of compounding. Effectively making your money work for you over time by earning returns on your principal and the accumulated income. This creates a snowball effect and allows your money to grow.

In investing, we see this happen practically through dividend investing. The chart below shows a hypothetical portfolio with 3 different outcomes:

Blue line - this is a portfolio of stocks with no reinvestment.

Red line - this is a portfolio of no growth dividend stocks.

Green line - this is a portfolio of dividend stocks that grow and reinvest their dividends.

If you look at the chart, for a long time (10 years), there isn't much difference in the three lines. But then compounding takes over and supercharges the return profile over the next 20 years.

Obvious stuff? Yes but there is a wrinkle. You have to ensure your portfolio manager is reinvesting the dividends back into the portfolio rather than paying them away or sitting them in cash.

Another thing to consider is the specific circumstances. If you are looking to use the dividend income to satisfy operating expenses or in the decumulation phase then reinvesting dividends might seem counter to your plan.

Compounding can work for you undoubtedly but each personal circumstance could require a different approach, so be pragmatic and don't always assume compounding is for everyone.