Compound interest

You may have heard of it. But do you truly understand the power of compound interest?

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Check out the chart below. $10,000 invested today (with no additional contributions) that grows at 9% per year (which is roughly the historical average return of the S&P 500 Index) and compounds annually would be worth $15,386.24 in 5 years, $23,673.64 in 10 years, $56,044.11 in 20 years, and $132,676.78 in 30 years.

If you are wondering why this chart curves up so sharply, especially after a decade or so, the answer is simple: compound interest. Like a snowball growing in size as it rolls down a snowy hill, compound interest can accelerate growth over time.

This snowball effect of compounding makes early saving or investing, particularly in tax-advantaged retirement accounts, that much more enticing since the earlier you start investing, the more compounded returns you can hope to make.

Compound interest up close

Compound interest is the interest income that accrues on an initial sum of money and any accumulated interest over time. This might compare to what some call "simple interest," which is simply the interest that grows only on a principal amount.

The amount you see at the end of your saving or investing time frame can be massively impacted by compounding interest. Several factors influence the value of compounded returns, including the time period, the interest or rate of return, the original investment or savings amount, and if additional contributions are made. To illustrate, consider how changes to the example above impact the end amount (see chart below).

Here are some clear takeaways from how changes in these factors can impact compounded returns:

  • Higher number of saving/investing years can lead to higher compounded returns.
  • Additional contributions can result in higher compounded returns.
  • A higher saving/investing rate can result in higher compounded returns.

Investing and compounding returns

The hypothetical examples above were simplified in that the interest rate, annual contributions, and other factors were fixed over the life of the investment period. Additionally, it did not consider after-tax returns.

Returns for stocks

Stocks have historically provided higher returns than less volatile asset classes. But keep in mind that there may be a lot of ups and downs and there is a generally higher risk of loss in stocks than in investments like bonds. Over the short term, the stock market is unpredictable, but over the long term, it has historically trended up.

While most of these factors can be consistent for savings accounts, for example, many are not when it comes to investing. Annual rates of return can vary from year to year, for instance (see sidebar).

Also, the amount and timing of contributions after the initial investment oftentimes fluctuate. You can potentially solve for this unknown by setting automatic contributions to retirement accounts, for example.

Of course, investing involves risk, including the risk of loss of your original investment. This has the potential to nullify the benefits of compounding returns. Additionally, short-term investment windows may not realize the benefits of compounding returns. For example, suppose you bought a stock, mutual fund, or ETF for its relatively high dividend and intended on reinvesting that dividend. If, for some reason, you sell before receiving and reinvesting any dividends, there would be no compounding returns on this position.

With all that said, the earlier you get started (with the intention of staying invested for some longer-term period of time) and the more contributions you make, the more you can take advantage of compounding returns.

With all that said, the earlier you get started (with the intention of staying invested for some longer-term period of time) and the more contributions you make, the more you can take advantage of compounding returns.

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