What is compounding?
Compounding is one of the most important terms for beginning investors to understand. It’s a way to potentially increase your savings, just by staying invested in the market.
In simplest terms, compounding is any return earned on your principal, plus your past returns. For example, if you have money in a bank account, it’s the interest on that sum plus the past interest it has earned over time. If you have money in an investment account, it’s the percentage you may earn on top of your original investment, plus its previous earnings.
Good to know: Principal is the original sum of money you put into an investment. Interest and earnings—the percentage you earn on your principal—can be calculated on a daily, monthly, quarterly, or annual basis.
How does compounding work?
Imagine that you deposited $100 in a savings account that accrues 10% interest annually. After one year, you’d have $110 in that savings account. After two years, though, your interest would have compounded, and you’d have $121.
That’s because you’re no longer earning 10% interest only on your initial deposit of $100 after one year—you’re earning 10% interest on $110. Keep in mind, however, that some experts currently predict that investing in almost anything will generate an annual return of less than 10% in the long run.
Note, however, that most banks don’t pay an interest rate as high as 10% on savings account deposits. The national average is only 0.09%, according to the FDIC. Also, interest isn’t always calculated on an annual basis—it’s sometimes calculated and compounded on a daily, monthly, or quarterly basis.
|Year 1||Year 2||Year 3||Year 4|
|+ 10% rate of return||$10||$11||$12.10||$15.31|
*Example is a hypothetical illustration of mathematical principles, and is not a prediction or projection of performance of an investment or investment strategy.
And after 10 years of compounding at a rate of 10%, your $100 deposit would grow to $259.37. That’s the power of compounding in action.
A compounding brain teaser
If you were offered the choice of $100,000 today, or a penny today, with the amount you receive doubled every day for a month (a penny on the first day, 2 cents on the second day, 4 cents on the third day, etc.), which would you choose?
Surprisingly, it’s actually smarter to start with the penny, because by day 31, you’d have more than $10 million.
The power of compounding…and automation
One of the keys to maximizing your financial potential is to save or invest money early, and often. Stash users can automate the process by enabling Auto-Stash tools, which can save or invest money automatically for you.
It can be a relatively easy way to compound your financial chores.
Make saving and investing a habit.
Go automatic with Auto-Stash.Start now
*The rate of return on investments can vary widely over time, especially for long term investments including the potential loss of principal. For example, the S&P 500® for the 10 years ending 1/1/2014, had an annual compounded rate of return of 8.06%, including reinvestment of dividends (source: www.standardandpoors.com). Since 1970, the highest 12-month return was 61% (June 1982 through June 1983). The lowest 12-month return was -43% (March 2008 to March 2009). The S&P 500® is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists. The S&P 500 is a market value weighted index and one of the common benchmarks for the U.S. stock market.