Take Advantage of Compounding
Whether you are investing for shorter or longerterm goals,
it is important to take advantage of compounding, says Pat Swanson,
CFP® and families specialist with Iowa State University (ISU)
Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).
“Essentially, compounding is earning interest on interest.
When the interest you make on an investment is reinvested or
left on deposit, interest is then earned on the original principal
plus the reinvested interest,” Swanson explains. “Compounding
also applies to reinvestment of dividends and capital gains on
stock investments.”
According to the new “Money Track/Investor Protection
Trust Investing Secrets Survey” conducted by Opinion Research
Corporation, investors do not understand the concept of compounding.
Fewer than two out of five investors (39 percent) understood
that if you have the choice of taking a million dollars today
or taking a penny that doubles in value every day for a month,
you’ll have more money if you take the penny.
To maximize the effect compounding can have on wealth accumulation,
it is important to start now. Even small amounts can grow significantly
over time. “The earlier you put money into an investment,
the more time the money has to compound and the more you can
potentially accumulate,” Swanson says.
The “rule of 72” is a simplified way to calculate
how long an investment will take to double in value, given a
fixed annual rate of interest. By dividing 72 by the annual rate
of return, you can get a rough estimate of how many years it
will take for the initial investment to double. For example,
$5,000 invested at 10 percent will grow to $10,000 in approximately
7.2 years.
Swanson outlines three steps that potentially will increase
your wealth. First, start investing today. Second, invest as
much as you can. And third, keep adding to your investments consistently
over a long period of time.
“Here are two scenarios to show how important it is to
start right now,” Swanson says. One individual puts $2,000
into an IRA each year for 10 years (assuming a 10 percent return
and no taxes) and then stops. A second individual waits 10 years
and then puts $2,000 into an IRA each year for the next 30 years
(same assumptions – a 10 percent return and no taxes).
At the end of 40 years, the first individual will have accumulated
$ 612,000– the original $20,000 investment has increased
30 times. The second individual only has $362,000– an increase
of only six times the original investment of $60,000.
“Of course if the first individual had not stopped investing,
the wealth accumulation would have been even more,” Swanson
says.
“Most individuals don’t increase their net worth
on wages alone. By investing wisely and taking advantage of the
power of compounding you can better reach your longterm goals,” Swanson
concludes.
The ISU Extension Invest Wisely
Project provides a series of newspaper, radio, and web resources
for investors. It is funded by a grant from the Investor
Protection Trust (IPT). The IPT is a nonprofit organization
devoted to investor education. Since 1993 the IPT has
worked with the States to provide the independent, objective
investor education needed by all Americans to make informed
investment decisions. www.investorprotection.org.
