Investing in the FTSE 100 gives you the potential to make a substantial amount of money. Every year I read stories of some who invest at the right time in a high-growth stock that soars. However, I also read about those who pour life savings into a stock only for it to halve in value. A lot of this stress about potential losses can be avoided by following my prime investing philosophy. I call it an investing secret as you’d be surprised how many people don’t know or follow it!
The investing secret is out of the bag
For experienced investors, the term compounding will be a familiar one. But for many new investors, you’ll have never heard about it. The premise is that the longer you leave an investment to benefit from profits that are reinvested, the more likely you are to achieve a higher return than previously.Â
Let’s take an example. You invest £1,000 in a dividend-paying stock. If we assume you receive a dividend yield of 5% per year constantly, then notice what happens over time. After one year your percentage return is 5%. But if you hold it for 10 years, then you benefit from compounding. The dividend you receive you can reinvest into the stock year after year. From a formula point of view, the return would be £1,000 x (1.05)^10. Take your original investment amount and multiply it by 1.05 (5% dividend yield) which in turn is taken to the power of 10 (that’s 10 years of compounding). The result is £1,628.90.Â
Compare this if you’d just invested for the short term. If once you received a dividend, you sold the stock and sat on the sidelines waiting for another opportunity, there’d be no compounding benefit! You’d be getting 50% profit over 10 years at best, instead of the compounded 62.8% shown above.
Compounding can also work without dividends. If you invest in a stock that enjoys share price growth of 10% per year, this also acts as compounding profits from your initial investment.
Why compounding is so powerful
Yes, it can be beneficial to be very active with frequent when buying and selling in the FTSE 100. You may have been able to avoid some of the market crash so far this year if you sold your stocks in early March and bought back at the low levels a couple of months later. But timing the market like this is exceptionally hard and frequent dealing costs can quickly add up.Â
So when looking to make a million and retire early, you need to allow your investment pot to build up over time, and not make short-term (often rash) decisions. Compounding rewards you for being patient and holding stocks for the long term. This is both from the dividends received but also from the share price appreciation over time as well.Â
If you do this over the course of a decade or two, then you can seriously be looking at making larger profits and obtaining the end goal of retiring early. So the way to get on this path is really to start building a pot as soon as possible. Then just allow the compounding impact to begin!