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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?

Eureka!

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 

What is Compounding?

Compound growth, or compounding, is when an investment creates earnings, and then those earnings generate more earnings.

Interest in a bank account

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. 

Casey is thinking ahead and planning for the future

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. 

Alex is all about the YOLO life

After 5 years, he follows Casey’s footsteps and contributes $1000 a year until retirement.

The amount of money they have after 10 years

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!

Casey's first 10 years

Alex has $7,654 after 10 years. At 34, Alex is lagging behind Casey quite a bit due to his late start to compounding.

Alex's first 10 years
 

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.

The amount of money they have at the age of 50

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. 

Casey's progress at 50 years old

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!

Alex's progress at 50 years old
 

The benefit of investing early

Starting early, even with a small amount, can result in a large multiplying effect on our money.

Compounding as soon as possible results in huge returns
Let's check out the effect of compounding when they reach retirement at age 65

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.

Casey at retirement

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.

Alex at retirement

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

Here's a video that shows compounding in another light.
https://www.youtube.com/watch?v=jTW777ENc3c&t=1s&ab_channel=OneMinuteEconomics

Glossary

What is Compounding?

When an investment creates earnings, and then those earnings generate earnings.