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There’s a simple word that has profound implications for savings and investing: compounding. Like a snowball that grows as it rolls down a hill, compounding provides the potential for your money to grow, reinvesting your investment earnings.
What is compound interest?
It's a basic model for growth potential, and the more you invest, the greater the opportunities to create long-term value. Even more simply put, it refers to a sum of money snowballing into more money after earning interest on itself.
Let’s take a look at some hypothetical examples to illustrate*:
If you invest $1,000 at age 20 and do not add anything to the principal, relying instead on 7.2% annual earning growth, you would end up with $32,000 at age 70.
If you wait until you’re 30, though, investing that same $1,000 that earns 7.2% annually, you would end up with $16,000 at age 70 — a decrease of 50%.
Finally, if you invest the $1,000 at age 20, earning 7.2% annually while contributing $83 a month until retirement, you would have $465,000.
How to calculate the impact of compounding
To estimate how long it will take for compounding to double an investment, use the rule of 72**:
Divide 72 by the annual rate of return. The answer is the approximate number of years it would take to double your investment’s value, assuming a fixed rate of return.
As an example: If you earn 9% annually, it will take 72/9 = 8 years to double the value of your investment.
Benefit of saving and investing early
The chart below from JP Morgan Asset Management's Guide to Retirement shows that by starting to save at as early an age as possible and saving regularly, can potentially lead to a more successful retirement. It shows that a 25 year old who was able to save and invest regularly with $96,000 at a 7% return ended up with a portfolio of $512,000 vs someone who waited until age 35 and had just $242,000.
Still not quite convinced? This chart included in a Business Insider article by Tanza Loudenback shows how an investor with $100,000 that invested for 30 years at a 7% return would need to continue to save just $155/month to reach $1 million, versus someone with 20 years to invest that need to save a whopping $1,150/month.
And I get it, it's all too easy to put off saving and investing for the future when you're living in the day-to-day and your focused on what you need your money for today. However, something as simple as eating out with your family one less time a month to save and invest an extra $50 can really make a difference in the long-run. It's easy to make it a habit by setting up an automatic transfer to a retirement savings account or bumping up your 401(k) by one or two percent. Trust me, the future you will be so grateful!
If you're interested in learning more about various savings strategies, please contact me about my investment management services.
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Disclosures
*These are hypothetical examples and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
**The rule of 72 is a mathematical concept and does not guarantee investment results nor functions as a predictor of how an investment will perform. It is an approximation for the impact of a targeted rate of return. Investments are subject to fluctuating returns and there is no assurance that any investment will double in value.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal.
Past performance is no guarantee of future results.