The Power of Compounding Returns

As we approach “The Most Wonderful Time of the Year”, I for one am looking forward to spending much needed quality time with family and friends reflecting on how fortunate I am to have every one of them in my life.  My two daughters who are 9 and 7 years old respectively, have been carefully crafting their wish lists for Santa and have been at it since Thanksgiving dinner ended.  They have been especially well behaved this year, so I have a funny feeling that they will be all smiles again on Christmas morning.

Unfortunately, when I look over the pages of requests they’ve made to Santa, I do not see anything that resembles starting an investment account.  That’s ok for now, I have that covered for them whether they know it or not!  But for others, thoughts of investing as early as possible are often overlooked as we can often get wrapped up with today’s events and miss out on putting the building blocks in place for future success.  I think back to past discussions with family and friends around investments, and many of these conversations rhyme with “I don’t have enough money to invest right yet, but when I do…”.  This type of thinking often misses out on harnessing the power of compounding returns and the benefits it provides in wealth accumulation.

Einstein on Compounding

Albert Einstein has been attributed to saying: “Compound interest is the eighth wonder of the world.  He who understands it, earns it…he who doesn’t…pays it.”  Now Einstein was a smart guy, but I don’t just want to just take his word for it.  I thought we’d put Einstein’s theory to the test and compare the results of different investment approaches.  Maybe this can shed some light on the power of compounding returns?

Compounding Returns in Practice

In this example, we compare the investment results for two different investors where each investor was able to achieve the average annual equity market return over the last two decades: +7.5%.   The first investor we will call “Early Bird”, as she started early by investing $1,000 annually in her investment account each year.  She contributed $1,000 to her investment account every year for 10 years, and then stopped contributing to her account in year 11 and would just let the balance grow with the market.  Overall, she has invested $10,000 from her own pocket (10 years contributing $1,000/yr) into her investment account.

The second investor we will call “Big Earner”. She had high hopes for her career and believed she was going to earn a larger salary later in life and figured that she’d start to invest when she earned more.  Her confidence paid off and she did start earning more and in year 11 she began investing.  She invested $1,000 annually for the next 30 years before she retired.  In total, she had invested $30,000 from her own pocket (30 years contributing $1,000/yr).

As you can see in the chart below, the “Early Bird” investor ended up with roughly $20,000 more in investment dollars at the end of 40 years despite investing $20,000 less from her own pocket. It looks like Einstein was onto something and starting early had a significant positive impact on the overall investment results.

Money makes money that makes money

Having a strong support system of family and friends is a crucial element to success in life as it’s easier to get things accomplished with the help of others.  I think of this the same way in achieving financial goals.  In the previous example, the “Early Bird” had been growing her investments starting year 1 when she began contributing to investments, and each year following these contributions began working for her and generating gains of 7.5% each year.  To show this in practice, she started year 1 with $1,000 but ended year 1 with $1,075.  That additional $75 that she earned will start “working for her” and generate additional returns in year 2 and onward, leading to a good explanation of compound interest as “money that makes money that makes money”.  It took 11 years before “Big Earner” began growing her wealth, and therefore it took longer for her money to begin to work for her. Getting your money to work for you early on in life has a significant impact on growing lifetime wealth.

It’s never too late to start

There is no amount that is too little and no time too late to begin investing and benefitting from compounding returns to help you achieve your financial goals.  As you saw in the example above, delaying the decision to begin investing delays the benefits of compounding returns.  At Bouchey Financial Group we encourage clients to get started investing early in life and urge teaching your children about investing as it will pay immeasurable dividends in the future.  Although the envelope with the 529 contributions in them won’t get much fanfare from my children this year, I know that these gifts will provide benefits that will last much longer than what Santa is bringing.

If you have questions about how to start investing today, please feel free to contact us to set up a meeting. Happy Holidays to you and your loved ones!

Related article:

Financial To-Do List for Recent College Graduates

Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.