The Power of Compounding

What is compounding, and how can it help when you save and invest? We'll explain—and show you how investing a little bit now could give you better returns than investing much more later.

How compounding works
Just what is compounding? It's what happens when an investment gives you a return on both the original amount you invested and on the returns you've already gotten.

For example, imagine that you put $1,000 into an investment that gives you a five percent rate of return each year. This would mean that every year, you get a five percent return on both your original $1,000 and on all the returns you've earned up to that point. Here's what could happen:

• In one year, you'd have $1,050 ($1,000 plus five percent, or $50)
• In two years, you'd have $1,102.50 ($1,050 plus five percent, or $52.50)
• In three years, you'd have $1,157.63 ($1,102.50 plus five percent, or $55.13)
• In 25 years you'd have $3,481.29—all without having invested a penny after the original $1,000

Just by sitting back and doing nothing, you would more than triple your money in 25 years—that's the power of compounding. And remember that this account gives you only a five percent rate of return—many investments have potentially higher rates.

Keep in mind that this example is hypothetical, and doesn't represent the actual results of a particular investment.

Time is money—and that's a good thing
You can think of money that's compounding as a snowball rolling down a hill. The longer the hill, the more time the snowball spends rolling—and the more extra snow (money) it could potentially gather on the way down.

The lesson here: The earlier you put money into an investment, the more time the money has to compound—and the more you can potentially gather in compound returns.

Too young to save for retirement?
So, does retirement seem a long, long way off? Do you think you're too young to worry about it? Then you're exactly the type who should start saving now.

If you have a long time to invest, that means you have more time to potentially profit from compound returns—which means that a small amount put aside now could prevent you from having to save a large amount later in life.

A little now, a lot later: A story
Just how much difference can compound returns make? Take the example of Louise and Keith. These two are the same age and worked for the same company. When she was 30, Louise enrolled in the company's retirement plan. Keith thought he was too young to worry about retirement, so he didn't enroll.

For seven years, Louise contributed $1,000 each year to the plan, investing a total of $7,000. Then, because she had children and wanted to put extra cash into their college savings accounts, she stopped contributing.

That same year—when Louise and Keith turned 37—Keith's parents retired. Keith saw his folks struggle to live on Social Security alone. So Keith enrolled in the company's retirement plan right away. For the next 31 years, he diligently contributed $1,000 each year to the plan, investing a total of $31,000—which is $24,000 more than Louise invested in her seven years.

So, who ended up with more? You might have guessed it: By the time they both retired at 67, Louise actually had a bit more in her retirement fund than Keith $200,310 to his $200,138.

To use the snowball-rolling-down-a-hill image, Louise's snowball—though smaller to start with—had more time to roll, so it collected the most snow. Just imagine how much she could have collected if she had invested in the plan every year until retirement.

Keep in mind that Louise and Keith are fictional characters and this example is hypothetical, which doesn't represent the actual results of a particular investment. This example is based on a 10 percent rate of return, compounded monthly, until the employees retired at age 67.

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