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The power of compounding: how ETFs help build wealth

This is episode 7 in our ETF series. If you missed it, read episode 6: ETF strategies for beginners: building a diversified portfolio

Albert Einstein reportedly called compound interest "the eighth wonder of the world." When it comes to building wealth through ETF investing, this principle becomes your most powerful ally. Let's explore how compounding works and why ETFs are particularly well-suited to harness its wealth-building potential.

Understanding the compounding effect

Compounding occurs when your investment returns generate their own returns. Unlike simple interest, where only your initial investment earns returns, compounding allows your accumulated earnings to generate additional earnings over time.

Real-world example:
Consider two Saxo Bank clients who each invest €10,000 in a global equity ETF with an average annual return of 8%:

• Client A withdraws the €800 earnings each year
• Client B reinvests all earnings back into the ETF

After 30 years:

• Client A has their original €10,000 plus €24,000 in withdrawn earnings (€34,000 total)
• Client B has approximately €100,000—nearly three times as much

The dramatic difference comes from compounding—Client B's returns earned their own returns year after year.

How ETFs amplify compounding power

ETFs offer several features that make them particularly effective vehicles for compounding:

Dividend reinvestment

Many ETFs offer accumulating share classes that automatically reinvest dividends, eliminating the temptation to spend these distributions and ensuring every euro works toward building your wealth.

Real-world example:
A €10,000 investment in an accumulating S&P 500 ETF over the past 30 years would have grown substantially more than the same investment in a distributing version where dividends weren't reinvested—even if you never spent those dividends but kept them in cash.

Low expense ratios preserve compounding potential

The lower the fees, the more of your returns remain invested to compound over time. ETFs' typically low expense ratios mean more of your money stays working for you.

Real-world example:
Two identical €10,000 investments earning 8% annually but with different expense ratios:

• ETF A: 0.1% expense ratio → approximately €97,000 after 30 years
• Fund B: 1.0% expense ratio → approximately €76,000 after 30 years

The seemingly small 0.9% difference in annual fees results in a €21,000 difference in ending wealth—over twice the original investment amount!

Tax efficiency enhances compounding

ETFs' structure often results in fewer taxable events than actively managed funds, allowing more of your gains to remain invested and compound over time.

Real-world example:
An investor in a high tax bracket might lose 25-40% of distributed capital gains to taxes each year. ETFs typically distribute fewer capital gains, allowing more money to remain invested and compound.

The time factor: compounding's best friend

The true power of compounding emerges over longer time periods, making ETFs ideal for patient, long-term investors.

Real-world example:
Consider a monthly €300 investment in a global equity ETF earning an average 7% annual return:

• After 10 years: approximately €50,000 (€14,000 in contributions)
• After 20 years: approximately €150,000 (€72,000 in contributions)
• After 30 years: approximately €340,000 (€108,000 in contributions)

Notice how the growth accelerates dramatically in later years—this is compounding in action. In the first decade, your contributions make up most of your portfolio value. By the third decade, your investment gains are doing most of the heavy lifting.

Practical steps to maximize compounding with ETFs

• Start early: even small amounts invested in your 20s can outperform larger investments started in your 40s.
• Choose accumulating ETFs: when available, select ETF share classes that automatically reinvest dividends.
• Minimize costs: select ETFs with low expense ratios to keep more money compounding.
• Stay invested: avoid the temptation to withdraw funds during market downturns.
• Add regularly: consistent contributions accelerate the compounding effect.

For Saxo Bank clients focused on long-term wealth building, understanding and harnessing the power of compounding through ETF investing is perhaps the single most important financial concept to master.

Next up: in episode 8, we’ll explore how to build "Income generation with ETFs: from growth to cash flow"