written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 6/28/2011
Compound interest is one of the most powerful investment features investors can uses to growth their portfolios. Selecting high interest compounding techniques will pay large dividends in the long run -- pun intended.
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Compound Interest: Investing for the Long Haul
Investors with a longer term investment horizon can use high interest compounding techniques to accelerate the growth of their investment portfolios. Investment growth can be through capital gains or streams of income like interest or dividends. Although it may be slower than a quick capital gain, compounding interest with some high yield investments can "yield" impressive results.
Using high yield compounding techniques involves a two step process: First, some high yield investments need to be researched and selected. Second, a program should be put in place to make sure those earnings do get compounded.
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Effects of Compounding
Investors can get an idea of the power of compounding by looking at an example. An investor decides to buy 1,000 shares of the Acme High Yield Mutual Fund. The fund has a current share price of $10 and is paying a 6 cent per share dividend every month for a 7.2 percent current yield. The investor will be reinvesting the dividend earned each month into more shares of the fund. For this example, the share price will stay level at $10.
In the first month, the account earns a $60 dividend payment. The dividend is used to buy 6 more shares, bringing the total shares to 1,006. The additional shares means the account will earn $60.36 the next month and the reinvestment buys 6.036 more shares. You can see how the number of shares and dividends continue to increase. Here are the account results after several periods of time:
After one year: Total shares owned: 1,074.424, monthly dividend: $52.82, account value: $10,744.24.
After five years: Total shares: 1,431.788, monthly dividend: $85.91, account value: $14,317.88.
After 10 years: Total shares: 2,050.018, monthly dividend: $123.00, account value: $20,050.18.
This hypothetical example has a level share price and no change in the interest rate, yet the account value has grown by over 400 percent and the original $10,000 investment is now generating over $3,000 per year in income.
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Investments for High Yield Compounding
The challenge in the current interest rate and investment environment is finding high yield investments that will perform over a multi-year period of time.
The automatic way to compound high yield interest is to invest in a high yield mutual fund and elect to have the dividends reinvested into more shares of the fund. Most high yield funds pay monthly dividends and a portfolio of several types of bond funds should produce compounding growth through different interest rate environments. For investors in the higher tax brackets, compounding with tax free municipal bond funds will produce growth that is free from income taxes.
Another possible choice for high yield investments is high dividend paying stocks. A portfolio of high yield stocks would throw off a stream of dividends that can be reinvested into more shares of the same or new high yield stocks. To compound the earnings, an investor would have to manually place the trades to buy more shares as the earned dividends are deposited into a brokerage account. Dividend paying stocks also provide the opportunity to invest in companies that have a history of increasing their dividend payout rates.
An investment plan of high yield compounding requires the investor to let time work in her favor, but she also must monitor the performance of the investments to insure they are meeting the original investment goals.