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Compounding
Date Added: June 1st, 2002

By Chris Stallman  |  E-mail

   Compounding is sometimes referred to as the "Eighth Wonder of the World" and it's also an investor's best friend. Why do people love compounding so much? Well, it's because compounding makes many people incredibly rich!

   You're probably wondering what compounding is so we'll get to the point. Compounding is actually a very simple concept. Compounding is the idea of earning money on what you have already earned. It may sound a little silly but it's really not.

   Here's an example: Let's say you are given $1000 by Aunt Susan for your 16th birthday. After sending her a big thank-you card for your new wealth, you decide it's best to put the money into a savings account that will pay you 3% interest each year. After one year, your $1000 would have grown into $1030 (1000 x 1.03). Because you then have $1030 in the savings account, you would make 3% on that the next year which would give you $1060.90. If you were really patient and kept the money in for 20 years, you would have $1806.11 because the money has compounded. That's $806.11 that you have made by doing nothing but being patient. However, if the money didn't compound, you would only have $1600, over $200 less.

   That's nice but didn't you say that it could make me rich? Yes, and now that you see how it works with a savings account, now you're ready to see the wonders that the stock market offers. Over the years, the stock market has returned an average of 13% per year so we will use this number for the following example.

   Compounding really begins to work when it comes to investing in the stock market. Did you know that if you invested that $1000 that Aunt Susan gave you into the stock market and kept it there for 20 years, you would have $11,523 compared to only $3600 if it did not compound.

   But compounding works the best when you start adding more time into it. Do you know how much you would have in 50 years, about the time of retirement? More than $450,000! And that's just with one investment! Imagine how much you would have if you added to that over the years!

   Because we are young investors, we have the advantage of time. When it comes to investing for the long-term, compounding and time go hand in hand. If you want to save $1,000,000 in 50 years, you would only have to invest $18 per month. However, if you start investing 20 years later, you would have to save $237 per month and your goals keep getting harder and harder to reach as time goes by. So, by investing at a young age, you're giving yourself a head start and beginning your path to becoming rich.

 

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