Whether you are investing for shorter- or longer-term 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 long-term goals,” Swanson concludes.