Compounding Periods: The more the merrier

I’ve spent time extolling the power of growth via compound interest in this blog.  The posts below demonstrate my belief in the 8^th Wonder of the World and what it does for Dividend Farmers.

• Average Growth vs Compound Growth
• Compound Growth
• 72 “Rules” – The Rule of 72
• Powerful Investment Growth with Compounding
• Would You Rather?

By definition, Dividend Farmers make full use of one of the 4 Things a Dividend Farmer Needs:  Time.

Time fuels compound growth.  Of equal importance are the number of compounding periods within the time frame.  Most investors understand the concept of time.  The longer the investment runway, the more opportunities there are for good things to happen or unfortunate things to be corrected.

The lesser known or understood factor relates to the number of compounding periods an investor can take advantage of.  Compounding periods are the segments of time within an investing horizon in which interest is accrued and reinvested to continue growing.

As examples, interest may be accrued once a year in which case it compounds annually.  Alternatively, it may be accrued four times a year resulting in quarterly compounding.  With some dividend stocks, dividends are paid (interest accrues) each month in which case those stocks compound monthly.

So what’s the difference between compounding across different periods?  If I’m being paid 4% each year, does it matter whether it’s paid out monthly, quarterly, or annually?  4% is 4%, right?  

No.  It’s not.

The following chart demonstrates the difference in outcomes for a hypothetical investor.  This person started with $1,000 and invested it in a dividend stock delivering a 4% yield.  The bar charts represent the outcome when the investment is compounded at different periods each year within a 10-year time frame.  In this example, the investor added $50 each month for the duration of the investing period.

Compounding Periods

The blue bar depicts the ending balance after 10 years if the investor puts money into a stock paying a dividend annually.  The orange bar represents the outcome when the stock dividend is paid out each quarter and immediately reinvested for the same 10 year period.  The green bar shows the results of monthly dividend payments promptly reinvested over the 10 year time frame.

The difference in money available between the blue bar (annual compounding) and the green bar is roughly $170 dollars.  This doesn’t seem like a lot, but it represents an advantage of 2%.  If one extends the time frame to 20, 30, or even 40 years, the advantage grows further.  The table below highlights the advantage of quarterly and monthly compounding relative to the baseline of annual compounding only. 

Compounded	10 Year % Advantage	20 Year % Advantage	30 Year % Advantage	40 Year % Advantage
Monthly	2.0	2.5	3.0	3.6
Quarterly	1.6	2.0	2.5	2.9
Annually	NA	NA	NA	NA

The strength of the compounding effect distinctly increases as the number of compounding periods within an investment horizon increases.  The advantage grows stronger yet as the time horizon lengthens moving from a 2% lead at 10 years to a 3.6% lead after 40 years when compounding monthly.  

This math is precisely why good financial advisors recommend their clients start saving early and often.  This also is why Dividend Farmers seek to plant their money crops as early as possible, exercise patience and care, and cultivate for the long term.  The more compounding periods you capture the merrier you’ll be and the faster it will happen.

Thoughts expressed here are those of the author, who is not a financial professional.  These opinions should not be considered investment advice.  They are presented for discussion and entertainment purposes.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.