Investing for the Long-Term – The Power of Compounding

Time is on your side when it comes to investing. The longer one has to invest, the greater amount of time one has to accumulate assets to provide for a comfortable retirement. I wanted to provide some basic information which should prove helpful in strategically investing for the long-term. The first topic within the series, “Investing for the Long-Term”, is the concept of compounding interest or compounding returns.

The idea of compounding is one of the most powerful concepts regarding investing. Compounding occurs when your investment earnings or savings account interest is added to your principal balance, forming a larger base on which future earnings may accumulate. Many use the phrase, “interest-on-interest” to describe the concept of compounding interest.

Imagine that our firm has a new client by the name of Jeff. Jeff decides to invest $10,000 into a brokerage account, comprised of traditional mutual funds. After the first year the portfolio gained 5%. The portfolio now has a value of $105,000 after year one.

Assume the portfolio returned 5% again in year two. The portfolio increase in year two is based off of the $105,000 value, which equates to an increase of $5,250, for a total value of $110,250 after year 2. The returns in year two were $5,250 vs. $5000 in year one, simply due to the effect of compounding. Each year of growth is derived from the higher value if returns are positive, which contributes to a larger portfolio value over the lifetime of the portfolio.

table 1

Many investors have heard the term, “the earlier you start saving, the better”. This philosophy goes hand-in-hand with compounding. The earlier one begins investing, the longer amount of time that the money can grow. Below is an illustration of how an investor saving earlier can achieve the powerful effect of compounding.

Consider two hypothetical savers, Emily and Dave. Emily invests $200 per month into a retirement account with 6% annualized rate of return starting at age 25. Dave starts saving $200 per month at age 35, just 10 years after Emily. Both continue to add $200 each month until they both retire at age 65.

By the time they are both 65, Emily has contributed $96,000, while Dave has contributed $72,000.

graph 1

At age 65, when both Emily and Dave are ready to retire, Emily has almost twice as much in her portfolio as Dave does. The value of Emily’s portfolio is $402,492, and Dave has a value of $203,118.

The power of compounding returns proved to be very favorable for Emily’s portfolio. The extra 10 years of compounding contributed to a portfolio value almost two times as much as Dave.

Albert Einstein is believed to have said, “compound interest is the eighth wonder of the world. He who understands it, earns it . . . he who doesn’t pays it ”. Such a powerful force should be taken advantage of by long-term investors today! Please stay tuned for further posts regarding long-term investing.