The Magic of Compounding
So far we’ve explained the main investment categories, and in a moment we’ll look at how much you should invest in each category, and how to go about doing so. But before we do that, it is essential for you to understand what Einstein supposedly called ‘the eighth wonder of the world’: compounding returns.
Do you remember back in Step 7: Plan Your Life, when we were calculating how much money you would need in future dollars, and how compounding inflation made the amount required increase faster and faster as time went on, and how you fled screaming and crying to your trailer and wouldn’t come out?
Yeah, you remember.
At that time I assured you that compounding would save you more than it would damn you, and I promised to show you why. Well, here you go.
Let’s say you invest $100,000 in the stock market and reinvest all returns. That means if you make a modest 6% in one year, you put that extra $6,000 into buying more shares rather than taking it out and spending it all on pimping your Hyundai Excel. What would happen in the long run?
Let’s say you make an average return of 6%. We’ll calculate this as exactly 6% a year for simplicity’s sake, but in reality, the returns would fluctuate madly and would sometimes be negative, as you saw in that section about shares.
You can use this online calculator to figure out how the original $100,000 might increase over time:
This is a calculator for interest rather than stock market returns, but it’s good enough for us to get a ballpark figure. Enter $100,000 as the principal, 6% as the ‘interest’, and then try entering a number of years as you please. Make sure to try out numbers >10, because as discussed, you’re supposed to hold volatile growth assets like shares for the long haul.
To do it yourself with an old-fashioned calculator, it’s the same as for when we were figuring out inflation earlier:
First year: 100,000 [+]  [%] [=] (you should get 106,000)
Second year: 106,000 [+]  [%] [=] (you should get 112,360)
Third year: 112,360 [+]  [%] [=] (you should get 119,102 rounded off)
You see? In the second year we’re adding 6% of $106,000, not the original $100,000, because we reinvested last year’s $6,000 in extra shares. Hence, we don’t make another $6,000 – we make $6,360. By the third year we’re making $6,742. This is compounding: returns on top of returns mean your money can grow faster and faster over time.
After five years you’d have $133,823. After ten years, $179,085. After twenty years, $320,714. And after thirty years, $574,349.
Not bad, hey? If you can afford to wait around thirty years (and if this is for retirement, maybe you can), then you made almost half a million dollars sitting on your bottom doing absolutely nothing. Of course, some of this would be eaten up by inflation, and there are also capital gains taxes, but you’re still way ahead.
If you continually add to your investment over time as most normal, employed people would, then the figures look even better. For example, say you start with $100,000 then add $500 of your savings per month, and assume an average return of 6%. You can use the same online calculator to figure it out – after thirty years you’d have the tidy sum of $1,048,698.
The actual numbers would vary because of the volatility of the market – it would never be exactly 6% per year – but you get the idea of the kind of returns that are possible if you are able to wait.
The key factor, as you can see, is time. The more of it you have, the richer you can become. If your financial goals chosen earlier seemed impossible, try putting them back a few years and recalculate. It will make a big difference. Compounding means that time is your friend, and all good things come to those who wait. Try not to die of old age in the meantime.
In real life, your returns might not be so rosy as compounding average returns suggests due to the downward drag of negative numbers when you lose money. Hit this endnote for a detailed discussion of why this is,[i] or just remember that compounding returns jump up and down in alarming ways not reflected in those calculations above, and that the end result is never certain.
Keep compounding in mind for the next section on choosing how to invest your money. Growth assets only help to build wealth if you can afford to leave your money there long-term and let compounding work its magic. If you might need the money sooner, lower performing defensive assets are more suitable. However, if you change the above calculations so that there is only a 4% rate of return, as might be expected from bonds, you can see for yourself that you’ll enjoy far less capital growth – perhaps not enough to reach your desired level of financial freedom.
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