Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” There is nothing I can add here and as you will see below, it is indeed the eighth wonder of the world.
I assume you have already heard about the power of compounding and probably, not once. Your math teacher or numerous articles in different personal finance magazines have already tried to explain what that is. Yet, many people still remain confused about how it works and how exactly to use it to their advantage. Please, notice my wording. I am not saying people do not use it. Conversely, many of us already utilizing it, for example, by having a simple savings account or a CD. My point here is that most of us do not utilize it to their maximum advantage. As I will show further, it is a very simple concept that does not require you to be a rocket scientist or possess high-school math skills in order to get it and benefit from it. All you are going to need is just to set a financial goal and have a hard discipline to pursue it. If you can do it then you will reap all the benefits of its power.
What is the Power of Compounding?
The power of compounding is one of the most important and critical concepts of successful investing and wealth creation processes. Sometimes referred to as “interest on interest”, the concept assumes earning interest not only on the principal amount, but also on any interest, dividends, and profits that were added to your account. That’s it. No more, no less.
To better understand how it works, let’s take a look at the examples below first and draw some conclusions after. For the sake of simplicity, let’s assume two persons, Person 1 and Person 2, both ages 25 willing to invest for the next 40 years, until age 65. Both persons have a $10,000 account balance each, earning 5% per year. No taxes and transaction costs.
Example 1: Person 1 reinvests all his interest and profits, while Person 2 does not, meaning interest payments stay constant (simple interest.)
As can you see, by simply reinvesting interest and profits, Person 1 was able to earn $40,400 or 134.6% more than Person 2, who decided not to do that. What an unforgivable error.
Example 2: this time both persons are reinvesting their profits and interest, however, Person 1 contributes additional $3,000 ($250 per month) a year, while Person 2 opts not to do that.
By consistently contributing $3,000 per year to his account, Person 1 was able to exponentially speed up his account growth and finish at the level of $432,799, which is $362,399 higher that Person’s 2 account value. Unbelievable what the power of compounding can do.
Example 3: finally, let’s now look at the case when both persons reinvest their profits and contribute $3,000 per year, but with one important difference: Person 2 starts investing at the age of 35, 10 years later than Person 1.
By delaying investing and contributing by 10 years, Person’s 2 account finished almost twice lower than Person’s 1. The only option to compensate for this loss is to either contribute more or seek for a higher rate of return. It is obvious, you are better off by simply starting investing earlier.
- Power of compounding is an incredibly powerful tool which you should incorporate in your investing process sooner rather than later
- Start investing as earlier as you can. No matter what your income, age, or current financial situation are. By doing so, you are getting a huge advantage by making the power of compounding work for you. Besides that, you are significantly increasing your chances of achieving financial goals (even prematurely)
- Reinvest all your profits, dividends, and interest. Reinvesting dramatically enhances and boosts your account value. Try to avoid withdrawing money from your investment account for as long as you can
- By contributing additional amount of money on a regular basis and reinvesting it along the way, you can achieve an exponential growth, where “the sky is the only limit”
- If you start contributing additional money earlier in your life, at some point you will be able to stop doing it. Thus, saving yourself money for other purposes
- It is free! You do not have to pay a dime for it. Simply enjoy the magic of numbers
Unfortunately, as I mentioned before, not all people reap the benefits of compounding. Why? Because it requires a hard discipline and sacrifices in the way of your living. You need to save and that means cutting on entertainment or fun. Nobody likes that. You need persistence and commitment because it takes a lot of time to start seeing the fruits of your labor. Not many are willing to wait. Long story short, most people find whatever reasons they want to, but continue to postpone not only investing, but also saving. I encourage you once again to look at the charts above and revise your priorities. Remember, your financial independence should be on top of it.