The magic of compounding returns
Lesson in Course: Investing basics (beginner, 4min)
It's a mistake to underestimate the cost of time. How much are we missing out on when waiting to invest?
What it's about: Compounding is how money can grow exponentially over time.
Why it's important: By investing, we take advantage of compounding so our money grows faster.
Key takeaway: Start investing early, no matter how small, and be patient. Compounding will lead to big gains in the long run.
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. - Albert Einstein
Compound growth, or compounding, is when an investment creates earnings, and then those earnings generate more earnings.
A simple example is the interest we earn in a bank account. Imagine we deposit $100, and we make $5 worth of interest the first year. The following year, we will earn interest on both the original $100 deposit and the $5 we made the previous year.
How compounding works
The effects of compounding become stronger the more time we give an investment to grow. To get an idea of how powerful compounding can be and the difference it makes in the long run, let’s look at an example of our two friends, Casey and Alex. They are both 24 years old, employed, and have a 401(k) retirement account at work.
Casey
Casey is our responsible friend, and she starts participating in her 401(k) this year.
She sets aside $1000 a year towards retirement, contributing for the next 10 years, and then stops after that.
Alex
Alex, while responsible, prefers to live in the moment. He puts off saving for retirement for 5 years and spends the money on traveling.
After 5 years, he follows Casey’s footsteps and contributes $1000 a year until retirement.
Casey has $16,888 after 10 years. At 34, Casey's earnings per year are now more than her yearly contributions of $1,000. Her investments add more to her account than she does!
Alex has $7,654 after 10 years. At 34, Alex is lagging behind Casey quite a bit due to his late start to compounding.
At age 50, Alex contributed a total of $22,000 to his retirement account while Casey put in just $11,000. Yet, Alex's account is only slightly higher than Casey's at this point. Since Casey started 5 years before Alex, her investments began compounding sooner, helping her account grow faster longer.
We might assume at this point that Casey is far behind Alex since she stopped contributing at age 34. At age 50, Casey has $49,857 and is only behind Alex by less than $3,000. By starting 5 years before Alex, Casey gives her original investments more time to compound.
Contributing $1,000 every year, Alex only barely manages to catch up to Casey at age 48. At age 50, he has $52,436 saved for retirement. Remember, Casey stopped adding money 14 years ago!
The benefit of investing early
Starting early, even with a small amount, can result in a large multiplying effect on our money.
Casey never contributed a penny more to the $11,000 early in her career. Over time, her investment's compounding growth netted her $126,558, or an 1,150% increase.
By age 65, Alex contributed a total of $37,000 over the years. Compounding growth on his investments earned him $134,561, a 363% gain. His account ends up with $34,000 more than Casey's.
The huge difference between Casey's 1,150% gain compared to Alex's 363% gain is because Casey started investing 5 years earlier. It’s important to note that the effects of compounding are magnified by higher rates of return. E.g., at 1% growth, the difference would be much less noticeable. Historically, the average annual return of the S&P 500, an index broadly measuring the US stock market, has been around 10%.
Actionable ideas
By starting to invest earlier like Casey, the effects of compounding allow you to earn more despite contributing significantly less. Starting to invest early, no matter how small, and being consistent over time will lead to significant gains in the long run. Be patient; compounding will take care of the rest.
Supplementary materials
Glossary
When an investment creates earnings, and then those earnings generate earnings.