Young people, especially those in their first full-time job, will sometimes neglect to save for retirement. Often there are competing priorities such as saving for a house or apartment, buying a car and all the other things required to start a life on your own. However, you’re never too young to begin building an investment portfolio. In fact, investing when you’re young can have the potential to produce impactful earnings gains. And that’s because of a simple concept: compounding.
Compound interest is interest that applies not only to the initial principal of an investment or a loan, but also to the accumulated interest from previous periods. In other words, compound interest involves earning, or owing, interest on your interest. Starting early is important, because the greater the number of compounding periods, the greater the compound interest growth will be. For savings and investments, compound interest is your friend, as it multiplies your money at an accelerated rate. But if you have debt, compounding of the interest you owe can make it increasingly difficult to pay off. Spending everything you earn and going into debt will make the power of compounding work against you.
Here is a hypothetical example to illustrate the power of compounding.
Let’s say that you invest $1,000 at age 20 and don’t add anything to the principal. You just compound earnings for 50 years until you turn 70. If you take a 7.2% annual rate of return, by age 70, your $1,000 would have grown to $32,000. Not bad.
Now let’s say you take the same approach but delay investing until you’re 30. So that $1,000 has 40 years to grow. And assuming the same annual rate of return of 7.2%, your $1,000 investment will have grown to $16,000. Not nearly as good. In fact, that’s a decrease of 50%.
Finally, if you invest $1,000 at age 20 and contribute an additional $83 a month – or $1,000 a year – until you turn 70, assuming that same 7.2% annual rate of return, your total savings will reach $465,000. Wow. That’s nearly 15 times the first example, and 30 times the second example.
To be clear, these were hypothetical examples and aren’t representative of any specific situation. They’re just to illustrate the power of compounding. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing so real-world results will vary.
There’s a fairly accurate formula that can help you estimate how long it would take for compounding to double an investment. It’s called the Rule of 72. Just divide 72 by the annual rate of return. The answer is the approximate number of years it would take to double your investment’s value, assuming a fixed rate of return.
As an example, if you earn 9% annually, it would take 72 divided by 9, or 8 years to double the value of your investment. Please note that this formula does not guarantee investment results and is just to give you an approximate idea of how quickly your savings can grow when compounding is at play.
While no investing strategy can guarantee success, delaying investing can put you at a significant risk of not meeting your investment and retirement goals. An important step is just to get started. Even small sums, invested early, have the potential to grow into something amazing over time. While there are always likely to be other ways to use your money, getting in the habit of living on a fraction of your income, may pay off over time, in part, thanks to the power of compounding.
To hear the podcast of the Smart Money Management radio show on this topic, or others, go to our website at alderferbergen.com.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal.
The rule of 72 is a mathematical concept and does not guarantee investment results nor functions as a predictor of how an investment will perform. It is an approximation of the impact of a targeted rate of return. Investments are subject to fluctuating returns and there is no assurance that any investment will double in value.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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