Many people underestimate the power of compounding. What is compounding, and why is it so beneficial? I’m sure most of you have seen those financial adviser commercials that ask individuals when they started saving and if they think they have enough money for retirement. Those commercials are focused on the power of compounding.
Compounding, in finance terms, is defined as the ability of an asset to generate earnings (interest, dividends, income), which are then reinvested in order to generate their own earnings. I will explain in more detail below. Before I do, I just want to point out that the millennial generation as a whole has typically overlooked the impact of compounding. After surveying a few of my friends (millennial age group) I found that most people: 1) Don’t invest at all; 2) Save money in low interest savings accounts, ones that are typically linked to a checking account or 3) Save money by holding cash and then using that cash to purchase things they feel they need at the time. The problem with points 1 and 3 above is that they all lack the ability to compound. The issue with number 2 is that while compounding may occur in the savings account, the rate is so small that the investor will not actually see returns from compounding interest. Additionally, having the savings account linked to the checking account makes the money more accessible and easy to transfer to the checking account, which again would hurt the money’s ability to compound.
So, how does compounding work and how can you get started? Let’s use a few examples to explain.
Example 1: Let’s say you have some extra money this month from your tax refund and you decide to save that money in a high yield savings account with an interest rate of 1.0% (many online savings accounts offer accounts around this rate) paid yearly. If you invest $2,000 today at 1%, a year from now you will have $2,020. If you leave the interest earned in the account, after two years you will have $2,040.20. Now, I admit that the return is not great, but it’s a start. Let’s look at another example.
Example 2: Similar to above, you take your tax return and invest that money in an index fund that tracks the S&P 500 or Dow Jones (general overall market index funds). On average, these funds return 6-8% per year with minimal fees. After year 1, assuming an average return of 7% for simplicity, the $2,000 investment would be worth $2,140. If that money is left in the account for another year, the earnings will compound to $2,289.80. This option offers better returns than the savings account, but still not jaw dropping. The reason is because you haven’t truly experienced the power of compounding yet. Compounding takes time; the longer the time period, the more effective the power of compounding is.
Expanding on example 2 above, let’s say you left that initial $2,000 investment in that account until retirement, and you retire 25 years from now, your investment would be worth $10,854,87. Your investment is worth 5 times as much as your initial investment and you didn’t need to do anything to generate that return. If you contributed annually to the same investment, your return would be even larger. For instance, if every year you put a $1,000 dollars from your tax refund into that same account, the value of that account after 25 years would be approximately $78,531.34.
For a better visualization of this concept, take a look at the chart below.
Millennials have time on their side. If you start today, and stick with it, you could be a millionaire by the time you retire. I put together the graph below which shows the monthly amount of money you need to save at each age to reach a million dollars by the time you are 65.
The power of compounding is impressive. Have you started investing or saving? If so, what did you do to get started?