Compounding returns is more than just some complicated lingo that a financial advisor uses. Compounding is necessary for most people to become financially independent. There is a reason why Albert Einstein said that the power of compounding is the eighth wonder of the world.
What is compounding?
Compounding is when you take a number and increase it over and over by a percentage like 10%. Contrasting with increasing a number by a fixed amount like 10.
Here’s an example that helps explain the difference between increasing by a percentage and a fixed amount. My wife and I just got a puppy, so we are going to start with 100 dogs to use as an example. One less than 101 so it’s not confused with Cruella’s dalmatians.
For a fixed return, we increase our dogs by 10 dogs for five years.
By the fifth year, we have 150 dogs.
That’s a lot of dogs.
To show compounding, we will increase our dogs by 10 percent for the same five years
By the fifth year, we have 161 dogs.
You end up with 11 more dogs.
This may not seem too exciting, (especially if you’re thinking about potty training all 161 dogs) but it’s easy to recognize the true power of compounding when looking at investments.
The compounding effect applies to your investments because they increase as a percentage. This snowball effect allows your growth to also grow. Turning a small amount of money into millions with enough time.
If you were 20 years old only investing $1,000 a year and getting a 10% return, you would have $481,593 at age 60.
If you put that same $1,000 each year under your mattress, you would have $40,000 (and a very uncomfortable bed).
The power of compounding return is incredible. Time is the most important ingredient. The longer you are invested, the more powerful the growth. That means that the sooner you start investing, the more powerful the growth. Most growth happens in the last few years. In the example, the final year’s increase was $80,145 compared to $1,100 in the first year.
Remember this example isn’t perfect because investments don’t increase exactly by 10% each year. There will be higher and lower years, but the concept of compounding returns stays the same.
How to maximize my compounding return
Compounding returns are necessary for most people to retire successfully. To take advantage of compounding returns, invest in stocks and bonds. You can invest inside a retirement plan at work, open your own account at one of the large brokerages, or help from a Spokane financial advisor.
Investing doesn’t come without risk. A financial advisor can guide you in determining the least amount of risk to take and achieve your goals. Make sure you are taking advantage of the compounding returns inside tax-advantaged accounts like a 401(k), IRA, or SIMPLE plan. Talk to a Spokane financial advisor to learn more about your options.
About the Author
Noah Schwab CFP® is a financial planner in Spokane, Washington who specializes in helping small business owners with retirement plans and personal finances.
Resources
· Learn more about compounding return: https://www.investopedia.com/terms/c/compoundreturn.asp
