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. Retirement

    Should Retirees Reinvest Their Dividends?

    Find out why dividend reinvestment may or may not be the right choice for retirees, depending on their financial needs in retirement and investment goals.
  2. Investing

    Understanding the Power of Compound Interest

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

    Continuous compound interest

    Different frequency in compound interest results in different returns. Check out how continuous compounding accelerates your return.
  4. Investing

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  5. Retirement

    Using Compounding to Boost Retirement Savings

    Allowing growth on your investments to compound over time gives you immense returns when saving for retirement.
  6. Investing

    Learn simple and compound interest

    Interest is defined as the cost of borrowing money or the rate paid on a deposit to an investor. Interest can be classified as simple interest or compound interest.
  7. Retirement

    Compounding Is Important in the Later Years Too

    The power of compounding is even greater in the later years of saving for retirement.
  8. IPF - Banking

    How Interest Rates Work on Savings Accounts

    Here's what you need to know to grow your rainy-day fund.
  9. Investing

    Investing $100 a month in stocks for 30 years

    Find out how you could potentially earn hundreds of thousands of dollars just by investing $100 a month in stocks during your working years.
  10. Investing

    5 Best Ways to Earn Interest

    Learn how to use tools to increase your interest earnings. Use compounding interest and breakpoints to increase your interest income.
Trading Center