We have all heard of compounding, but let’s break it down to bare basics because compounding is one of the most important concepts to understand when managing your finances.
I love this quote by Albert Einstein – “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” I want you to be the one who understands it.
What is compounding?
Compounding is your investments’ growth over time as you continue to reinvest your starting amount (principal) plus each year’s return.
Here is a simple example. Let’s assume you have $100. Imagine you just won a lottery, and you will be getting paid an extra $10 a month for the next six months (I know, not an exciting win, but stick with me). $10 is 10% of $100.
Month 0 (when you start): 100
Month 1: 100 + 10 = 110
Month 2: 100 + 10 + 10 = 120
Month 3: 100 + 10 + 10 + 10 = 130
Month 4: 100 + 10 + 10 + 10 + 10 = 140
Month 5: 100 + 10 + 10 + 10 + 10 + 10 = 150
Month 6: 100 + 10 + 10 + 10 + 10 + 10 + 10 = 160
Total extra money after 6 months: $60.
Compounding works differently. Let’s assume you were promised to get a 10% return every month. You don’t just get an additional 10% of your original $100 every month. Instead, you get an additional 10% of your total dollar amount every month:
Month 1: 100 + (100 x 10%) = 110
Month 2: 110 + (110 x 10%) = 121
Month 3: 121 + (121 x 10%) = 133
Month 4: 133 + (133 x 10%) = 146
Month 5: 146 + (146 x 10%) = 161
Month 6: 161 + (161 x 10%) = 177
Total extra money after six months of compounding: $77.
As you can see, when the number is compounded, you end up with more money in the end.
It works both ways
Going back to Albert Einstein’s quote, compounding can work for you or against you.
For example, if you put your money in a savings account, your balance will increase every year, and the power of compounding will be in your favor.
However, if you owe money to a bank by having a credit card debt, the power of compounding will work against you.
How does compounding work with investing?
When it comes to investing, compounding is the increasing value of an asset due to the interest earned on both a principal and accumulated interest.
I look at compound interest as the science of money making money. When the value of investments you own goes up (or down), that makes the balance in your investment account go up (or down). As long as you leave the difference invested, your returns have the opportunity to compound over time. The longer you let your money compound, the greater potential returns are.
Stocks are typically the riskiest part of any investment portfolio. Historical data shows that they have gone up in about 75% of the years since 1928. The stock market’s average annual return has been about 9.8%.
That’s why investing is such a fantastic vehicle for generating wealth. Getting started ASAP is very important because the longer your money is invested, the more opportunity it has to compound over time.
The power of starting early
The principle of compounding makes me very passionate about teaching kids about the basics of investing. Children’s most significant advantage is having lots of time to compound their money. When you start investing early, it is effortless to get rich!
To illustrate the importance of starting to invest early, let’s look at the example below. We have three friends – Kim, Rachel, and Sarah. We will assume that their annual investment was $2,000 each, and they earned 10% annually on their money. Let’s ignore taxes for the sake of simplicity.
- Kim started investing early, at age 19. She invested $2,000 a year for 8 years (from age 19 to age 26) and then never touched her investments or added a penny to it. At age 65, she will have $1,035,160 in her investment account! Think about it! Over ONE MILLION DOLLARS! Her net earnings would be $1,019,160 (the value of her portfolio minus her total investment of $16,000).
- Rachel started investing later, at age 27. She contributed $2,000 to her portfolio for the next 39 years for the total investment of $78,000. At age 65, Rachel ended up with $883,185 in her investment account or $805,185 in net earnings. That’s $213,974 less than what her savvy friend Kim made!!!
- Sarah is a smart cookie. She started investing early, at age 19, just like Kim. But unlike Kim, she kept adding $2,000 to her portfolio every year until she turned 65. Sarah was able to take full advantage of the power of compounding and investing early. At age 65, she had $1,918,345 in her investment account! Almost TWO MILLION DOLLARS! Her net earnings were $1,824,345 or $1,019,160 more than Rachel’s!
The bigger picture
Compound interest is one of the most powerful tools you have as an investor to grow your wealth over time.
Getting started to invest ASAP is very important, especially for us women. There is no time to waste because the longer your money is invested, the more opportunity it has to compound over time.
But more importantly, mom, teach your kids the basics of investing and set them up on a path to a secure financial future. It’s all in your power.
Get the confidence to start your investing journey ASAP
when you read through our Ultimate Guide to Investing: