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The power of compounding returns

Compounding returns occur simply by reinvesting any interest income and dividends paid by your holdings to generate additional returns. In the case of many mutual funds, distributions can be taken in cash or reinvested automatically into additional units of your chosen investments. Although taking regular distributions in cash can be a good way to pay for your current financial needs, reinvesting these payments back into your mutual fund holdings means more of your money grows over time – because you can earn money on the amounts you’re reinvesting.


Let’s look at an example.*


Say you invest $1,000 in a mutual fund priced at $10 per unit, so you buy 100 units. If the fund pays a distribution of $1 per unit, you receive $100. Assuming the fund remains at $10 per unit, you can reinvest your distribution in the fund and receive 10 more units, for a new total of 110 units. Next year, the fund pays another distribution of $1 per unit, but now you will receive $110 because the distribution is also paid on the 10 additional units you had previously reinvested in the fund. With each subsequent distribution, your money has the potential to grow faster and faster as any income you reinvest in the fund will earn income of its own.


That’s the power of compounding.


*Please note this example is hypothetical and for illustrative purposes only. This example does not take into account any changes in share or unit values or any fees or income taxes that may be payable by the investor. The investment amount and fund price referenced are in Canadian dollars.

It may not seem like much now, but compounding can have a dramatic impact on your long-term returns. Let’s look at another example.**



**This chart is for illustrative purposes only. It represents the growth of a hypothetical C$500 monthly investment, assuming the stated 5% annual nominal rate of return is compounded monthly, over a specific time period. This example does not take into account inflation, redemptions, switches, or any applicable fees/deferred sales charges and should not be considered to be representative of any specific product or investment strategy. The chart is only used to illustrate the potential effects of the compound growth rate and is not intended to reflect future values of a specific investment or returns on investment in a specific investment.

Reinvesting your payments to take advantage of the power of compounding has been shown to be an effective strategy for growing your savings over longer periods of time. And the earlier you start, the more time your money has the potential to grow.

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CLEMENT CHUNG, CFP, CLU

Certified Financial Planner

Fee-Based Financial Planning
Burnaby & Metro Vancouver

©2018 by Clement Chung.