The word compounding describes what happens when your investment earns money and this amount is reinvested and generates more earnings.
Time and compounding is a simple equation with potentially powerful long-term results.
Compounding — the best kept secret of long-term investment success.
“How did it get so late so soon?” — Dr. Seuss
Dr. Seuss’s whimsical take on life has been delighting children of all ages for generations. His simple, but powerful words continue to resonate today, even in the context of planning for a financially secure future. Because when you get right down to it, the younger you are, the more you potentially have to gain by taking advantage of the time ahead of you.
Compounding: A Snowball Effect
The word compounding describeswhat happens when your investment earns money and this amount is reinvested and generates more earnings. The process of compounding has often been compared to the way a snowball grows as it rolls downhill. You might say that a longer investment time frame is akin to a bigger hill, because each creates conditions for greater growth potential.
And thanks to the potential role of compounding, the more you invest, the more significant the potential long-term benefit. For example, assume that two workers both earn $30,000 annually. Each invests 6% of income and receives a 3% raise each year. Investor A never increases her investment, but Investor B increases her investment by 1% of income each year until she is eventually investing 12% of income. Over the course of 30 years, each account earns an 8% average annual investment return.
The result? At the end of the 30-year period, Investor A would have $296,864, whereas Investor B would have $535,005 — simply because she took advantage of time and gradually increased her investment amount.1
Time and Compounding — A Simple Equation
One easy way to estimate how long it may take for compounding to help double the value of an investment is to use the “rule of 72.”
Here’s how it works: Divide 72 by the rate of return earned by an investment. The number you end up with equals the approximate number of years it would take for the investment to double in value, assuming it continues to earn the same return. For example, an investment earning an 8% annual return would double in value in about nine years (72/8 = 9).
Stay in It for the Long Term
Maintaining a long-term time frame may also give you the luxury of being able to tolerate short-term market volatility. Because while past performance cannot guarantee future results, it’s worth noting that longer-term holding periods have often been associated with a lower likelihood of portfolio losses.