Return on return
This is how the ‘eighth wonder of the world’ works
One of the best reasons for long-term investing is the return-on-return effect. Read on to find out how this can work to your advantage.
Investing involves risk. You could lose all or part of your initial investment.
Compound interest
Albert Einstein is once said to have described compound interest (interest on interest) as the ‘eighth wonder of the world’. He added: ‘He who understands it, earns it; he who doesn't, pays it.’
Compound interest works like this: if you get interest on the capital you’ve accrued every year, you don’t only get interest on your original amount, but also on the interest you earned in previous years. Your capital grows even faster. But the same is true when you pay interest on a debt: the interest-on-interest effect means that your debt grows too.
How does return on return work?
When you invest, you earn a return rather than interest, which is why we refer to this as the return-on-return effect. Here’s how it works: When you invest money, it might earn you a return, increasing the value of your investment. If you leave your investment and the return in your account, you can earn a return on both your original investment and the previous return. This way, your capital keeps on growing.
One way of benefiting from this is through periodic investing. This involves investing smaller amounts at fixed intervals so the amount that can earn you a return continues to grow.
Example
Return on return over a period of 15 years
Imagine you invest a lump sum of €1,000 and, after a year, you have a 5% return, giving you €1,050 (1000 x 1.05). The next year, your return is also 5%. Your investment increases to €1,102.50 (1050 x 1.05). In other words, your investment grows by €50 in the first year, and by €52.50 in the second. In the 10th year, it will grow by €77.56, and so on. The longer you leave your investment, the more it will grow because you’ll be receiving a return on your return. Particularly if you keep investing periodically. This is a good reason for starting to invest as early as possible, when you have a long horizon. This is how it looks in a table:
| Year | Total value | Return |
|---|---|---|
| After 1 year | € 1,050.00 | € 50.00 |
| After 2 years | € 1,102.50 | € 52.50 |
| After 3 years | € 1,157.63 | € 55.13 |
| After 4 years | € 1,215.51 | € 57.88 |
| After 5 years | € 1,276.28 | € 60.77 |
| After 6 years | € 1,340.10 | € 63.82 |
| After 7 years | € 1,407.10 | € 67.00 |
| After 8 years | € 1,477.46 | € 70.36 |
| After 9 years | € 1,551.33 | € 73.87 |
| After 10 years | € 1,628.89 | € 77.56 |
| After 11 years | € 1,710.34 | € 81.45 |
| After 12 years | € 1,795.86 | € 85.52 |
| After 13 years | € 1,885.65 | € 89.79 |
| After 14 years | € 1,979.93 | € 94.28 |
| After 15 years | € 2,078.93 | € 98.99 |
Please note: we have used a fictional annual return of 5% in this calculation, and assumed that you can afford to leave the original sum and continue to invest periodically for a period of 15 years.
Return on return with periodic investing for a period of 15 years
Imagine that you start by investing €1,000 and periodically invest €50 per month. The table below shows how much you would earn over a period of 15 years, assuming a return of 5%:
| Year | Periodic deposit | Totale value | Return |
|---|---|---|---|
| After 1 year | € 600.00 | € 1,677.93 | € 77.93 |
| After 2 years | € 1,200.00 | € 3,395.78 | € 117.85 |
| After 3 years | € 1,800.00 | € 5,155.92 | € 160.14 |
| After 4 years | € 2,400.00 | € 6,960.77 | € 204.85 |
| After 5 years | € 3,000.00 | € 8,812.81 | € 252.05 |
| After 6 years | € 3,600.00 | € 10,714.58 | € 301.77 |
| After 7 years | € 4,200.00 | € 12,668.73 | € 354.15 |
| After 8 years | € 4,800.00 | € 14,677.91 | € 409.19 |
| After 9 years | € 5,400.00 | € 16,744.88 | € 466.97 |
| After 10 years | € 6,000.00 | € 18,872.45 | € 527.57 |
| After 11 years | € 6,600.00 | € 21,063.52 | € 591.07 |
| After 12 years | € 7,200.00 | € 23,321.03 | € 657.51 |
| After 13 years | € 7,800.00 | € 25,648.03 | € 726.99 |
| After 14 years | € 8,400.00 | € 28,047.63 | € 799.60 |
| After 15 years | € 9,000.00 | € 30,523.03 | € 875.40 |
Please note: we have used a fictional annual return of 5% in this calculation, and assumed that you can afford to leave the original sum and continue to invest periodically for a period of 15 years.
Things to watch out for to earn a better return
Work out how much risk you are willing to take
Do you want to run a low or a high risk with your investment? Or somewhere in between? In general: the higher the risk you run, the more likely you are to generate high returns. But the chance of losing your money is also higher. Diversifying your investment can reduce the risk. Spread your investment between shares, bonds, investment funds and ETFs (Exchange Traded Funds), for example. And you can invest in different sectors or topics.
Be patient
Start investing as early as possible to increase your chances of earning return on return. And don’t expect fast results: investing is a long-term endeavour. So make sure you only invest money you’re not likely to need in the short term. How much patience do you need? This is easier to estimate if you have a clear goal. Are you investing to buy a camper van, go on a trip around the world, or for your retirement or children’s education? Once you’ve decided on your goal, you can think about when you need the money and how much risk you’re willing to run. You can also calculate your possible return to work out how much to invest. But always be aware that your calculation is only an estimate of your potential return.
Be aware of the fees
In order to maximise your return on return, you should be aware of the fees. If you frequently buy and sell shares or investments in funds, you will have to pay transaction fees every time. This is usually at the expense of your return. You can buy some investment products free of charge. If you have Self-directed Investing, for example, you won’t pay fees for transactions within ABN AMRO’s basic range of ETFs and investment funds.
Consider periodic investing
You don’t need to invest a large amount in one go to start investing. You could invest a smaller amount at intervals over a longer period of time. We call this periodic investing. If you invest periodically, your returns are more resistant to stock market volatility. Dips in the market will not hit you as hard. Needless to say, even though you’re investing small amounts, it is still important that you only invest money that you don’t need right now. You could lose all or part of your initial investment.
Read more about investing
The more you know about investing, the more likely you are to make the right choices. What type of investor are you, and how much risk are you willing to run? We have an investment guide to help you understand the various investment options, the risks, and the choices open to you.
Investing involves risks
Investing involves risks. You could lose (some of) the money you invested. If you are going to invest, it is important that you are aware of this. Invest with money you can spare. Read more about the risks associated with investments.