Most people understand why it’s important to put away money for retirement, their children’s college costs and other major events. But they don’t always grasp how “compounding” can convert small differences in investment returns to huge differences in the amount they are able to accumulate. Hence, they may not take the time to properly invest the money they do save.
Note: As discussed elsewhere on this website and by many other resources, investments that produce higher returns over the long term often experience fluctuations and/or illiquidity over shorter time frames, plus possibly higher entry and exit costs. So if you need the money you are saving in the next month to 4-5 years, it’s recommended that you invest in lower return assets with little or no risk of loss for those needs.
To calculate the amount of money you will have at a future point in time, there are three basic variables: 1) the amount invested, 2) the length of time the amount is invested and 3) the rate of return.
The concept of compounding is as follows: If you invest $1,000 today at a 5 percent return, at the end of a year you will have $1,050 ($1,000 + $1,000 X .05) – a profit of $50. Then that $1,050 will be worth $1,103 ($1,050 + $1,050 X .05) at the end of year 2 – a profit of $53 in the second year. Then in the third year you will make $55 ($1,103 X .05), or 5.5 percent of your original $1,000 which you invested at 5 percent. The amounts will continue to grow as your earnings make money too: At the end of year 5, you will have accumulated $1,276, and after 30 years you will have $4,322 – having earned over $200 (almost 21 percent of your original $1,000) in the 30th year alone
Impact of Compounding – Rate of Return
Using a more realistic scenario, say you invest $100 per month, every month. In this case, each monthly installment compounds from the date contributed. The math is more complicated, but conceptually the results are the same.
Note: Also in a real-world scenario, if you invest in an asset, such as stock, that regularly fluctuates in value even as it proceeds along a long term trend-line, sometimes you will be buying relatively expensive stock (when the price is high relative to the trend-line) and other times you will be buying relatively cheap stock. Whether it’s better for you to invest steadily through good times and bad, or to develop a strategy that adjusts purchases as markets fluctuate is beyond the scope of this article.
After 30 years you will have invested $36,000. At a 1 percent return you will have accumulated $41,998, or a profit of $5,998 (16.6 percent total return). Increasing your return to 2 percent would increase your profit to $13,355 (37.1 percent total return). So a mere 1 percent change in your annual return would give you over $7,000 more cash on $36,000 invested.
If you achieve a 9 percent return on your investment (most studies put long term returns of the stock market somewhere in the 9 percent ballpark), your $36,000 will be worth over $148,000 – a profit of over 3 times your original investment.
So the point is – returns matter. It’s worth your time and effort to pay attention to even small differences in prospective return rates.
Impact of Compounding – Time
We will try to illustrate the impact of time on amounts accumulated simply, with one scenario. Our purpose is to convey the concept, not provide the math that would allow you to calculate every possible set of circumstances, especially since in the real world most people invest differing amounts at different times.
Every $10,000 invested at 5 percent at the age of 25 will be worth a little over $70,000 at the age of 65. Every $10,000 invested at 5 percent at the age of 35 will be worth a little over $43,000 at the age of 65. Every $10,000 invested at 5 percent at the age of 55 will be worth a little over $16,000 at the age of 65.
The point here is that an early start in investing can have a big impact on the amount accumulated by the time the money is needed.
The power of compound returns, although not always mentioned explicitly, is fundamental to most long term investing strategies. It amplifies the impact of your investing decisions. So we hope that we have adequately conveyed this message so that you take the time to carefully consider your investing options. Your choices will make a huge difference in your long term results.