1. Investing 101: Introduction
  2. Investing 101: What Is Investing?
  3. Investing 101: The Concept Of Compounding
  4. Investing 101: Knowing Yourself
  5. Investing 101: How Technology Has Changed Investing
  6. Investing 101: Types Of Investments
  7. Investing 101: Portfolios And Diversification
  8. Investing 101: Conclusion

Compounding is the process of generating more return on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. Compound interest can help your initial investment grow exponentially. For younger investors, it is the greatest investing tool possible, and the #1 argument for starting as early as possible. Below we give a couple of examples of compound interest.

Example #1: Apple stock

An investment of $10,000 in the stock of Apple (AAPL) that was made on December 31, 1980 would have grown to $2,709,248 as of the market’s close on February 28, 2017 according to Morningstar’s Advisor Workstation tool. This translates to an annual return of 16.75%, including the reinvestment of all dividends from the stock.

Apple started paying dividends in 2012. Even so, if those dividends hadn’t been reinvested the ending balance of this investment would have been $2,247,949 or 83% of the amount that you would have had by reinvesting.

While Apple is one of the most successful companies, and their stock is a winner year-in and year-out, compound interest also works for index funds, which are managed to replicate the performance of a major market index such as the S&P 500.

Example #2: Vanguard 500 Index

Another example of the benefits of compounding is the popular Vanguard 500 Index fund (VFINX) held for the 20 years ending February 28, 2017.

A $10,000 investment into the fund made on February 28, 1997 would have grown to a value of $42,650 at the end of the 20-year period. This assumes the reinvestment of all fund distributions for dividends, interest or capital gains back into the fund.

Without reinvesting the distributions, the value of the initial $10,000 investment would have grown to $29,548 or 69% of the amount with reinvestment.

In this and the Apple example, current year taxes would have been due on any fund distributions or stock dividends if the investment was held in a taxable account, but for most investors, these earnings can grow tax-deferred in a retirement account such as a employer-sponsored 401(k).

Starting Early

Another way to look at the power of compounding is to compare how much less initial investment you need if you start early to reach the same goal.

A 25-year-old who wishes to accumulate $1 million by age 60 would need to invest $880.21 each month assuming a constant return of 5%.

A 35-year-old wishing to accumulate $1 million by age 60 would need to invest $1,679.23 each month using the same assumptions.

A 45-year-old would need to invest $3,741.27 each month to accumulate the same $1 million by age 60. That’s almost 4 times the amount that the 25-year old needs. Starting early is especially helpful when saving for retirement, when putting aside a little bit early in your career can reap great benefits.  

 


Investing 101: Knowing Yourself
Related Articles
  1. Investing

    Reinvesting Your Mutual Fund Dividends

    Learn the benefits of reinvesting your mutual fund dividends, their impact over time, and when it is better to take the dividend payments as cash.
  2. Investing

    Understanding the Power of Compound Interest

    Understanding compound interest is important for both investing and borrowing money.
  3. Retirement

    Reinvesting Dividends Pays in the Long Run

    Find out why dividend reinvestment is one of the easiest ways to grow wealth, including how this tactic can increase your investment income over time.
  4. Investing

    How Dividend Reinvestment Grows Your Money Faster

    Dividend reinvestment is a smart strategy for growing your investments faster over the long term, but it’s not a get-rich-quick proposition.
  5. Investing

    Got Dividends? Here's How to Reinvest Them

    Reinvesting dividends is a good idea if you intend to hold your shares for the long term.
  6. Investing

    Creating A Dividend Portfolio For Young Investors

    Young investors should build their portfolios around dividend growth and put the magic of compounding to work.
  7. Financial Advisor

    The Awesome Power of Compounding

    The power of compounding. It may not be sexy, but it is the surest way to accumulate wealth over time.
  8. Personal Finance

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Do you know the difference between Annual Percentage Rate and Annual Percentage Yield? Check out how they can affect your own account balance.
  9. Investing

    How to Make the Time Value of Money Work for You

    How to make the time value of money and power of compounding work for you. Here's a hint: Start saving now.
  10. Financial Advisor

    How mutual funds pay dividends: An overview

    The process by which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Here's a look.
Frequently Asked Questions
  1. What do the numbers that follow the bid and ask numbers in stock quotes represent?

    These numbers are called the bid and ask sizes, and represent the aggregate number of pending trades at the given bid and ...
  2. What is the Exponential Moving Average (EMA) formula and how is the EMA calculated?

    Learn the formula for calculating both simple moving averages and exponential moving averages, indicators that are frequently ...
  3. I placed a limit order to buy a stock after the market closed, but the stock's price gapped above the entry price and my order never got filled. How can I prevent this from happening?

    You can minimize the chances of this situation happening if you understand two types of orders: the buy-stop order and the ...
  4. China vs Hong Kong stock: Is H-shares and A-shares the same?

    Learn what the difference between A-shares and H-shares of publicly listed companies in China and Hong Kong stock exchange. ...
Trading Center