Compounding returns: the exponential wealth maker

Each week across the ACM network Ali and Gaby Rosenberg offer quick tips for big wins in understanding your money. The sisters are co-founders of the Blossom micro-investing app.

Too many financial products and instruments are unnecessarily complicated. We may work in finance, but we're the first to admit it (and probably the most determined to change it!). Unfortunately, it means that the people who end up making the most money are the ones who already have it, and understand it. It's like there's an invisible bouncer, and to get in, you need to speak Credit Default Swaps.

In the spirit of making things simple, let's look at compounding returns, (including compound interest). This is one of those things that's hard to calculate, but definitely not difficult to benefit from, so stick with us. You invest, you earn a return, you leave it invested, and now you earn a return on your principal investment, plus your return.

You're earning money not just on the money you started with, but also on your earnings - and it grows over time, exponentially. The rate of return offered by banks or financial institutions is usually stated annually (e.g. 2.5% per annum, 5% per annum) but it can be compounded daily, monthly, or annually.

Here's a simple example: Just say you deposited $100 in an account with a return rate of 5% p.a., compounded annually:

After one year: You've earned 5% p.a. of $100, which is $5. Your new balance is $105

After two years: You've earned 5% p.a. of $105, which is $5.25. Now you have $110.25

After three years: You've earned 5% p.a. of $110.25, which is $5.51. Your balance is $115.76

And so on. Where it becomes slightly more complicated, but more rewarding, is when your annual returns are calculated (and added to your balance) daily, or monthly. This is a better deal overall, given that your balance has more frequent contributions and your principal investment grows faster. So in the above example, 5% p.a. based on 365 days a year with returns posted daily is $115.92 after 3 years.

The alternative to compounding returns - and the one you may be more familiar with - is simple interest. With simple interest, interest is paid out on the first principal amount, without any accumulated earnings. It's more commonly used, probably because it's easier to understand, and in some situations (like when you're taking out a loan), the predictability of the interest to be paid helps both the lender and the borrower manage risk.

We love compound returns for savers, because it means that the overall rewards are bigger, and it's pretty satisfying to watch the incremental growth of your balance without having to invest any more. Your money makes money - and shouldn't it be working as hard as you do, after all?

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Sisters Ali & Gaby Rosenberg are the co-founders of Blossom App.