How to make return-on-return effect work for you

Let's talk about what Albert Einstein called the eighth wonder of the world. He contemplated about compound interest, also called the return-on-return effect. Read on for a concise explanation and the reason why this concept is so worth knowing.

What is the return-on-return effect?

The return-on-return effect is the reason why accumulated return in a given year will itself yield returns in all subsequent years.

In order to properly explain the return-on-return effect, we use a fictitious calculation example here where we assume the return on your investments is 5% each year. In reality, your return depends on the risk you take. Also, your return will fluctuate and not be a fixed percentage. This example does not take into account risk, nor does it take into account any fees you actually pay.

Suppose you put in €100 every year for 30 years and get a 5% return from your investments every year.

Now you might think that you then accrue 5% of €100 = €5 in returns each year. In that case, after 30 years you would have earned 30 x €5 = €150 in returns on top of your deposit.

How the return-on-return effect works

After the first year, you won't have €100, but rather €105, because you have gained €5 in return.

In the second year, you put in €100 again at the beginning of the year andnat the end, you receive another 5% return, in this case over €205. This amounts to €10.25 return. €10 on your €200 deposit and €0.25 on the €5 return from the first year.

That €0.25 is called the ‘return-on-return’.

That extra penny may not seem like a lot, but remember that you will receive a new return on your return every year, so this amount keeps increasing!

After the third year, you receive €15.76 return on your deposit, of which €0.76 is the return-on-return. So your return-on-return has tripled in one year!

As the years go on, this effect gets bigger and bigger. Take a look at the chart below. The y-axis shows the value of your money in euros, the x-axis shows the time in years. You can see that the total value of your portfolio in the first few years does not differ that much from your deposit.  Over time however, your portfolio becomes worth more and more relative to what you put in. That is the  positive impact of the return-on-return effect.

Your return becomes higher than your deposit

By the end of the fifth year, 10% of your return that year already consists of return-on-return. And after 15 years, your return is already almost 30%! If you look even further, after 25 years, you will see that your total return, at that time €2,511, is higher than your total deposit, of €2,500. You can check the figures for this example in the table at the bottom of this blog.

The amount you put in obviously has a big effect on the return. But two factors are perhaps even more important in return-on-return:

• The rate of return
• The duration

Rate of return

The effect of the rate of return is incredible. If you use a fixed annual return of 4% instead of 5% for this example, then after 30 years of depositing €100 each year, the final value will not be €6,976 but €5,833. If you get not 5% but 6% return per year, you end up with a whopping €8,380.

Duration of investment

In addition, the longer you keep investing, without selling your investments, the stronger the effect. In the long run, just one year more or less can make a big difference. If you put in €100 for not 30 but 31 years, at the end of the ride at a fixed annual return of 5%, you will not have €6,976 but €7,429. A difference of more than €450 in just one year!

Seen this way, it is not at all surprising that Einstein called the return-on-return effect the eighth wonder of the world. It's up to you as an investor to make that miracle work for you.

How you can make the return-on-return work for you

Set aside money regularly and most importantly: be patient! The Peaks app makes this easy with its easily adjustabvle automated deposit settings. It's designed for longterm use, be it for your own funds, your kid's or your pension! 

You need to know that investing is not saving, or keeping money under your mattress. Investing involves risk and this means you may lose (some of) your investment.

Know that investing takes risk and you may lose (part of) your investment.