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Investing Basics

Resources: Investing Basics: Compounding

Compounding is considered one of the most powerful calculations in mathematics. It is the mechanics behind the phrase, "Letting your money work for you" - that is, when you make a contribution or investment of principal, it earns interest, and as that interest is reinvested, you earn interest on both principal and the interest it has previously earned. Interest can be paid annually, quarterly, monthly, or daily.

How compounding works

Compounding happens when an investment gives you a return on both the original amount you invested and on the returns you've already received.

For example, imagine you put $1,000 into an investment that gives you a 5% rate of return each year. This would mean that every year, you get a 5% return on both your original $1,000 and on all the returns you've earned to that point. Here's what could happen:

  • In one year, you'd have $1,050 ($1,000 plus five percent, or $50).
  • In two years, you'd have $1,102.50 ($1,050 plus five percent, or $52.50).
  • In three years, you'd have $1,157.63 ($1,102.50 plus five percent, or $55.13).
  • In 25 years, you'd have $3,481.29 — all without having invested a penny after the original $1,000.

Compounding allows your investment to more than triple in 25 years. This example is based on receiving a 5% rate of return; some investments have potentially higher rates.

This example is hypothetical, and doesn't represent the actual results of any particular investment.

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Too young to save for retirement?

The key to a financially successful retirement is to start early and save often. If you start saving for retirement when you are young, the value of compounding combined with making regular contributions into a retirement account can help generate a substantial amount over time. The more time this process has to work, the larger the end payout can be.

This means that a small amount put aside now could potentially prevent you from having to save a large amount later in life. (Just ask Jane and Sam from the story below.)

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A little now, a lot later: a story

Just how much difference can compounded returns make? Take the example of Jane and Sam who are both the same age. When she was 30, Jane started investing for retirement. She got a 8% rate of return, compounded annually. Sam thought he was too young to worry about retirement, so he didn't invest.

For nine years, Jane invested $1,000 each year, investing a total of $9,000. Then, because she had children and wanted to put aside extra money for college tuition, she stopped contributing to her retirement account.

That same year - when Jane and Sam turned 39 - Sam started investing for retirement, also getting a 8% rate of return, compounded annually. For the next 29 years, he diligently contributed $1,000 each year to his retirement fund, investing a total of $29,000 - which is $20,000 more than Jane invested in her nine years.

So, who ended up with more? You might have guessed it: By the time they both retired at 67, Jane actually had a bit more in her retirement fund than Sam - $125,662 to his $112,283!

Just imagine how much she would have accumulated if she had invested every year until retirement.

This example is hypothetical, and doesn't represent the actual results of a particular investment. This example is based on a 8% rate of return, compounded annually, until the employees retired at age 67, and does not factor taxes/fees/expenses associated with the investment.

The moral of this story: Invest wisely now and reap the benefits of compounding!

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How to start investing now

Successful investing should start as a routine based on taking some simple steps, one step at a time.

Jane and Sam, in the story above, used a system of dollar cost averaging. This is a technique of investing the same dollar amount on a regular basis, such as once a month, into the same fund. As the market moves up or down, Sam and Jane are making the same contribution regardless of where the market is at any time. Over time, this reduces the average purchasing price of each share in the mutual fund. To learn more about this process, read the article Dollar Cost Averaging.

Dollar cost averaging does not assure a profit or protect against loss. Investors should weigh their ability to sustain investments during periods of market downturns.

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