How compounding works
Compound growth occurs once you begin to earn money on the previous earnings of an investment. Sometimes people refer to this as the “snowball” effect or even “interest on interest.” For example, a $100 investment grows by 10% in the first year thereby delivering earnings of $10. In the following year, the investment earns 10% again. This time the earnings are $11 because you’re earning money not only on the principal but also the earnings from the previous year.
Why compounding matters
The concept of compounding is important because it illustrates the importance on a long-term strategy. If an investor becomes impulsive and repeatedly changes their strategy, they will not have the opportunity to grow their portfolio exponentially.
Most importantly, compounding shows us why getting starting to invest early is critical. Consider this example: An investor puts $5,000 into a mutual fund at age 25 and continues to invest $5,000 per year. By the time they reach 65 their portfolio will be worth $1,142,811 assuming an annual growth rate of 7%. That’s a nice nest egg. However, if they wait and start investing at 35, their portfolio would be worth only $540,741 when they reach 65. Compounding accounts for the vast difference in earnings.
Using compounding to become a millionaire
Immense wealth rarely comes overnight. Successful investors repeatedly work at a goal for decades without deviation or liquidation. Saving just $361 per month from the age of 20 will yield a total of $1 million by 65 assuming a 6% annual return. The longer you wait to start the more you must save. If you’re already 30 by the time you start you’ll need to invest $698 per year.
Remember, the concept cuts both ways. For those mired in debt, compound interest can be the “snowball” chasing you downhill. You don’t need to be wealthy to benefit from compound growth in the stock market. However, you don’t need to be poor to experience the increasing burden of compound interest on borrowed money.
To win the compounding game you need to start early, remain consistent and learn to sacrifice today. That last part is important. The most difficult aspect of compounding is that it requires you to forgo the consumption of a dollar today. The insignificant retirement accounts of many people today illustrate the difficulty of saving. For some, it’s a budgetary problem. For others, it is a will power problem. Regardless of the hurdles, any investor seeking long-term growth must save today to earn tomorrow.
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