It is said that Albert Einstein once noted that the most powerful force in the universe is the principle of compounding. In investing and finance, this force manifests itself through the concept of compounding returns.
In simple terms, compound interest means that you begin to earn interest on the interest you receive, which multiplies your money at an accelerating rate. In other words, if you have $500 and earn 10% in interest, you will have $550. Then, if you earn 10% interest on that, you end up with $605. The process continues until, eventually, your original $500 is eclipsed by the amount of interest you have gained.
This is one reason for the success of many top investors. Anyone can take advantage of the benefits through a disciplined investing program.
Three Elements That Determine Your Compound Returns
Three factors will influence the rate at which your money compounds. These are:
- The rate of return, or the profit, that you make on your investment. If you are investing in dividend-paying stocks, this would be your total profit from capital gains and dividends.
- Time left to grow. The more time you give your money to build upon itself, the more it compounds.
- The tax rate, and when you have to pay taxes on your interest. You will end up with far more money if you don’t have to pay taxes at all, or at least not until the end of the compounding period rather than at the end of each year. This is why tax-deferred accounts, such as the traditional IRA, Roth IRA, 401(k), and SEP-IRA, are so important.
Keep in mind that with traditional IRAs and 401(k) plans, you will owe taxes at your normal income tax rates at the time when you take the money out. So, the taxes you'll owe can effectively compound at the same rate as the account's vale.
Compound Returns and the Time Value of Money
The foundation behind compounding interest is the concept of the time value of money, which states that the value of money changes, depending upon when it is received. Having $100 today is preferable to receiving it a few years from now, because you can invest it to generate dividends and interest income. Compounding allows that money to grow. By postponing the receipt of the $100, your opportunity cost grows.
Opportunity cost is the loss of possible gains if an action is not chosen—in this case, the amount of money you do not receive if you take no action with it. If you have not invested the $500, you have lost the opportunity to earn $50 you could have gained in a year with a 10% return. In 10 years, your $500 would have been $1,427.
When you understand the time value of money, you'll see that compounding and patience are the ingredients for wealth. As an example, if you wanted to have $1 million for retirement and could save $800 per month, with an 8% return per year on your investments, would you be able to reach your goal? The U.S. Securities and Exchange Commission provides a calculator to help you figure out how long it would take. (In this scenario, you'd break $1 million in 29 years.)
Compounding Results Over Time
The best way to understand these concepts is to put them into a compound interest table that shows you just how substantially your wealth can multiply over time.
Imagine an investor who sets aside a lump sum of $10,000. Take a look at the table to see the influence of time and rate of return on this investment. Once you understand the effects that build over time, it becomes evident that saving money is not the only key to a large fortune.
|Compound Interest Chart|
For instance, a 20-year-old who invests $10,000 today and parks it in Treasury bills, earning 4% on average for the next 50 years, will find himself with $71,067 if the purchases were made through a tax-free account such as a Roth IRA. Had he invested in stocks and real estate, earning a 12% average rate of return over the same time, he would have ended up with $2,890,022. Adding asset classes with higher returns would result in over 40 times more money, thanks to the power of compounding.
Resist the Temptation of Higher Returns Through Risk
You may want to do whatever it takes to earn a higher rate of return, although that can be dangerous, because higher rates always bring higher risk. Unless you know what you're doing, no matter how successful you are along the way, you always want to avoid the possibility of losing more than a budgeted amount of investing principle.
Benjamin Graham, known as the father of value investing, was aware of this risk when he said that more money has been lost reaching for a little extra return or yield than has been lost to speculating. He warned that it is one of the greatest temptations that new investors face when building a portfolio.