The Power of Compounding

As Albert Einstein once said, “The most powerful force in the universe is compound interest.” Although ‘most powerful’ could be a stretch, in an investment portfolio compounding does wonders. For example, consider you have $100 right now and are willing to put it in the stock market receiving the historical average return of 11% over the next 50 years without adding or removing any money. Let’s take a look:

1^st Year- $111

2^nd Year- $123.21

3^rd Year- $136.76

4^th Year- $151.81

5^th Year- $168.51

10^th Year- $283.94

25^th Year- $1,358.55

50^th Year- $18,456.48

Impressive, eh? In the first few years not a whole lot occurs, but over time your measly $100 starts gaining some nice momentum. To understand how compounding works, you have to know what three basic factors influence your returns:

1. The amount of money you initially invest per year

2. The growth rate of your investment

3. How long you keep your money invested

All these factors are important in maximizing returns; basically, depending on the amount of money, the growth rate, and the amount of time you hold the investment, your returns will fluctuate. However, one factor stands out above the other two. To see what it is, let’s look at a possible scenario:

 John and Mary are both twenty years old and are going to start their first full time jobs. John starts investing right off the bat, and for the next 25 years he invests $1,000 a year and never adds any more once he turns forty-five. On the other hand, Mary doesn’t see a need to invest money until she turns forty, and so from forty on she invests $5,000 annually. They both receive the stock market average return of 11% a year and retire at age seventy. Who has more money in the end?

If you are one of the few to guess John, then you are 100% right! Check it out:

John: $1,725,337.19

Mary: $1,104,565.87

Even though John invested only one sixth as much as Mary, his twenty extra years of time made him over half-a-million bucks richer. Compounding is definitely powerful, but time is the key to riches. We hope we showed you that the sooner you start –even with limited capital– the better off you will be in the end.

We’ll assume that most of you don’t want to figure out using mental math (is that even possible?) what you can personally achieve through compounding, so here is a compound interest calculator you can play around with: http://www.moneychimp.com/calculator/compound_interest_calculator.htm

Have a fantastic holiday, everyone! Remember to check back for more posts where we do our best to make sense of your cents!