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The Power Of Compounding

April 15, 2016

  • Compounding is the interest on the earnings and the interest your principal makes
  • Compounding can help your money grow exponentially
  • The earlier you start investing, the more compounding can work for you
3 min read

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.

How does compounding work?

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.

Fun facts: 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.

Puzzle me this

But instead of talking about compounding in abstract terms, here’s a fun brain teaser that might help you visualize the potential power of compounding:

Let’s say someone offered you the choice between $100,000 today, or a penny doubled every day for a month, which would you choose?

If you think it’s a trick question, you’re right, it is. It’s actually smarter to take the penny doubled every day for 30 days, because it amounts to more than $5 million on day 30, thanks to the power of compounding. The following day, on day 31, you’d have more than $10 million.

Here’s what that looks like:

Example is a hypothetical illustration of mathematical principles, and is not a prediction or projection of performance of an investment or investment strategy.

How compounding works

While the above example shows you how compounding can really pay off, there’s a big problem with it. It assumes a 100% return on your original investment of one cent, every day for 30 days. That’s not a reasonable expectation in the real world, and markets and the financial world don’t work that way.

However, over the last 100 years, stock market returns have generally averaged about 10% annually, although with some notable exceptions. (Returns on equities are estimated to be closer to 4% over the next five years, according to some experts.)

For simplicity’s sake, however, if we assume a 10% return, here’s how compounding can still work in your favor:

Let’s imagine you invested $100, and your hypothetical investment averaged a 10% annual return.

After the first year, your $100 would earn 10%, or $10. So, you’d have $100 + $10, or $110.

In your second year, you’d start with $110, and earn 10% of that, or $11. So you’d have $110 + $11, or $121.

In your third year, you’d start with $121, and earn 10% of that, or $12.10. So you’d have $121 + $12.10, or $133.10

If you held your investment for 20 years with the same average annual return, your initial investment of $100 would be worth $672.75. So you’re actually making your money work for you, thanks to the power of compounding.

Example is a hypothetical illustration of mathematical principles, and is not a prediction or projection of performance of an investment or investment strategy.

The trick with compounding is that the sooner you start putting money away, the more it can work in your favor. No matter how small your savings are to start, it has the potential to really add up.

What does compounding mean for your money?

Compounding works with a penny, $5, or $1 million. So invest what you can afford, on a regular basis, and let compounding work for you.

And remember, as a young investor, time is on your side. In order to reap the benefits of compounding, start now and let that time work in your favor.

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*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.

By Stash Team

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