The Miracle of Compounding
Albert Einstein is widely reported to have made the following statement, 'The most powerful force in the universe is compound interest.â€ While I'm not sure it is the most powerful force in the whole universe, I would suggest that compound interest is the most powerful force in growing your savings and investments. The key to maximizing the force of compound interest is to start saving from an early age. The earlier you start, the more powerful that force will be.
So what is compound interest?
To put it simply it's interest earning interest. I like to compare growing your savings and investments to building your own workforce. Every dollar that grows in your savings and investments is like another employee working for you to generate income. If you are patient and disciplined, your money (employees) will work for you and make a huge difference in your account balance over time. Think of compounding interest like a snowball rolling down a hill. At first it grows slowly, but as it continues it grows faster and faster because with every revolution it collects more and more snow (interest).
Here is an example of how compounding works with your savings. Each time you are paid interest on your savings your balance grows so that the next time you receive interest you are not only earning interest on your original balance, but also on all of the interest that you have received in the past.
Here is an example of how compounding works on your investments. Each time you receive dividends and you automatically reinvest them back into the fund or stock to buy more shares you will grow your position size. The next time you receive dividends you are not only receiving dividends on your original shares, but also on all the new shares purchased with reinvested dividends—so your account balance will grow faster and faster as the years pass. Compounding is particularly evident in retirement accounts, where the principal is allowed to grow for years tax-deferred.
As another example let's say you begin with two separate $10,000 investments that each earn 6% a year. In one $10,000 investment, you withdraw your dividends and capital gains in cash each year, and the value of your account stays steady.
In the other investment you don't cash out your dividends—they get automatically reinvested buying more shares. If you keep reinvesting the dividends after 20 years, your account balance will have grown by more than $20,500. If you start saving for retirement at a younger age, say in your 20's, after 40 years your account balance will have grown by more than $92,000.
In this example, you are not contributing any new money to the investment; you are just allowing it to grow on its own. If instead you were to have made regular monthly contributions to the investment the effect of compounding would have been magnified even more.
As another example let's say you invest $2000 a year from the age of 22 to the age of 32, then you stop. If you let the money compound at 10% for 28 years without touching it until you are 59 1/2, your account balance would be $505,629 after only investing a total of $20,000.
On the other hand, if you waited until you were 32 to start investing and then invested $2000 a year for 28 years until you were 59 1/2 you would only have $295,262 even though you invested $56,000!
Answer this question: if someone said they would give you a penny and then double the amount you have every day for 30 days, or give you 1 million dollars which would you choose? I'm pretty sure most people would take 1 million dollars but if you instead chose the first option you would have $10,737,418.24. More than 10 million dollars in a single month! The example above may be an exaggeration of the power of compounding, but it illustrates how in the beginning the growth is slow but as time goes on the growth increases exponentially. The original penny turned into two, but then those two turned into four, and the four turned into eight, and so on. The growth of your money sped up because not only was your original penny collecting interest â€“ but all the pennies you received as interest also began to earn interest and so the growth accelerated or compounded.
The examples above show why it is important to start saving and investing while you are young and also the importance of using the power of compounding to your advantage. I know it is not always easy to put money away as I have struggled with it myself, but once you start and learn discipline it does get easier.
Another positive effect saving has, is the reduction in stress that you feel not having to worry about living paycheck to paycheck. You get a very comforting feeling knowing that you have a financial cushion and that you can handle any emergencies that may come along.
I cannot stress enough how important it is to start while you are young. The quality of your future does depend on it!
Thank you for Reading.
Donald Hancock ~ Real Life Trader.