Albert Einstein famously referred to compounding as the eighth wonder of the world. He should know, because his career was a great example of the power of compounding. His journey wasn’t a single leap to fame but a series of incremental successes and learnings that compounded over time.
The concept of compounding isn’t limited to finance; it’s equally applicable in personal and professional development. However, here we will focus on its relevance to personal finance.
Start with Simple Interest
Every day, we see examples of simple interest. Let’s say you invest $1,000 in a bank CD that pays 5% a year for five years. You will earn $50 every year, and by the end of five years, your total investment will have grown to $1,250 (= $1000 + 5 x $50). That’s simple enough to understand — pun intended.
Now, imagine if the CD lets you automatically add the interest you earn each year, causing the CD to grow annually. Therefore, at the end of the first year, the CD will have grown to $1,050 and will start to earn an additional 5% interest on the $50 interest earned. By the end of the second year, you will have earned $52.50 in interest, bringing your CD’s value to $1,102.50. This process will continue for the remaining three years. In the end, you will have $1,276.28. That’s about $26 more than what you would earn from simple interest.
Compounding in Action
Not impressed? Try this out for 10, 20, and 40 years. After 10 years, the amount grows to approximately $1,629. That’s a $129 increase over the yield from simple interest. After 20 years, it grows to $2,653, which is $653 more than the $2,000 you get from simple interest. After 40 years, it increases to $7,040, outpacing the simple interest amount by $4,040. So, after 40 years, your original $1,000 investment through compounding becomes more than twice as large as it would with simple interest accumulation. Pictures convey this more powerfully, so here’s one for a 50 year period.
Compounding works its magic when you invest methodically over a long period. Keep your costs low. Avoid losing money to taxes. Costs and taxes add friction to the compounding machine.
Like many tools and techniques in life, compounding acts as a double-edged sword. It also applies to debt. Don’t allow your debt to compound. Use debt strategically to finance well-defined opportunities, such as purchasing a home. Otherwise, aggressively attack debt until you completely eliminate it. This method stops debt from gaining a foothold and beginning to compound.
Rules to Harness the Power of Compounding
- Start Early: Even small amounts invested regularly can grow substantially over time.
- Invest Regularly: Consistency is key. It will reinforce your habit of saving.
- Reinvest Earnings: Allow your interest, dividends, and capital gains to be reinvested. Preferably automatically, but you may choose to accumulate cash and periodically reinvest it.
- Time is Your Friend: Compounding takes time. Real growth often occurs in the later years. The legendary investor, Warren Buffett, started investing when he was 11. However, 99% of his current wealth was created after his 50th birthday!
- Mind the Costs: Costs add friction to an otherwise well-functioning compounding machine. Pay attention to costs. For example, if the returns are the same, choose a lower cost fund or ETF. For example, there are many funds/ETFs that track the S&P 500. Why would you pay 0.5% fees to own one when another is offered at 0.1%?
Compounding is one of those simple but powerful ideas. It’s your long-term friend. Remember, it doesn’t just apply to your finances. It also applies equally well to your personal and professional life. Start early and keep at it, a little bit at a time. And the results will show over time.
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