We've seen compounding referred to as "the most powerful force in the universe," "the royal road to riches," and "the greatest mathematical discovery in human history."
Albert Einstein called compounding the eighth wonder of the world.
Compounding is a simple investment strategy in which you put your money in an investment that pays a return. At the end of the year, you take your return and reinvest it with your original stake. Your dividend, or interest, earns a return, too, building a bigger dividend -- or higher interest payments -- the next year.
A snowball is the best analogy for compounding. As you roll the ball through the snow, the surface area gets bigger. The more surface area on the snowball, the more snow it picks up. The snowball gains mass slowly at first... but pretty soon, it's so large you can't move it.
Compounding is slow and boring at first. But gradually, the dividends grow, and your reinvestments increase. One day, you wake up to find your account producing thousands of dollars per year in dividends and your wealth a giant snowball.
Here's a mind-blowing example from a study conducted by Richard Russell of the Dow Theory Letters on the power of compounding:
An 18-year-old girl puts $2,000 into an account each year from the ages of 19 to 25, then stops contributing and lets it compound at a rate of 10% until age 65. That means she has contributed only $14,000 in total. But because of compounding, by age 65, she's almost a millionaire, with $944,641 in her account.
Now, let's say this girl has a twin brother. He's not as disciplined and continues to blow his money on useless things. Finally, at age 26, he realizes he needs to start saving, too.
He puts $2,000 per year into his account starting at age 26. He also lets his money compound at a rate of 10% until age 65. Except he contributes $2,000 every single year from ages 26-65. That means he's contributed $80,000 in total... more than five times what his sister has contributed.
By age 65, he's almost a millionaire, too, with $973,074 in his account.
Who's the winner?
The sister contributed only $14,000 (2,000 per year over seven years) and ended up with $944,641. That's a net gain of $930,641, or 66 times her original investment.
The brother contributed $80,000 ($2,000 per year over 40 years) and ended up with $973,074. That's a net gain of $893,704, or 11 times his original investment.
The sister was able to accomplish much better results with much less money... all because she realized the power of compounding money over long periods of time.
If you missed this, go back and read the example again until you realize what happened.
Not only is compounding an incredible wealth builder, but it's also simple to do. First, you need an investment that generates a return every year for many years in a row. Then, you need time and perseverance to let the dividends grow.
Compounding doesn't require vigilance, activity, or effort to make it work. In fact, it works best when you forget about it altogether.
Action to Take --> This is why compounding is by far the best investment strategy for your children or grandchildren. They have time to let the dividends accumulate, and they won't think about their accounts every day.
EconomicsWe share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
EconomicsWill remaining calm and staying long present significant risks to your investment health?
EconomicsDue to creative measures by central banks, there is no telling when a recession will actually occur, but natural economic forces will eventually win.
InvestingAs an alternative investment, income-seeking investors may turn to dividend-paying exchange traded funds (ETFs) as a way to seek both income and growth.
Stock AnalysisThe stock market can't seem to make up its mind. Will investors end up with coal for Christmas or might their wishes come true?
EconomicsDiscover which countries produce the most oil in the Middle East, a region long known for its influence on international petroleum markets.
EconomicsDiscover which African countries produce the most oil, and learn more about which domestic and international oil companies operate in each country.
EconomicsFind out which countries produce the most oil in Latin America, and learn about some of the biggest oil companies operating in each country.
Stock AnalysisLearn about the top energy companies in Russia, a country that holds some of the largest reserves of oil, natural gas and coal in the world.
Stock AnalysisLearn which Asian countries deliver the most crude oil to market, and discover what companies are the biggest producers in each country.
An industry agency council was established by the World Economic Forum in 2014 to serve as an advisory board on the future ... Read Full Answer >>
The railroads sector is comprised of publicly traded stocks for companies that operate railroad tracks and/or trains. Railroad ... Read Full Answer >>
Biotech giant Amgen Inc (AMGN) bills itself as one of the first biotechnology firms. It was founded in 1980 and has grown ... Read Full Answer >>
Back in late August 2012, Apple’s (AAPL) stock price reached nearly $700 per share. The stock has since split but has yet ... Read Full Answer >>