**Compounding** is often either ignored or forgotten about by most people when it comes to investing. **Compound interest** is when you **earn interest on top of interest**. We have discussed **compound interest** earlier however when discussing investing the magic of compounding can never be overstated. The earlier you invest the more you can benefit from **compounding interest**; this is exactly why investing early is so critical. People often ask about what is the best investing strategy, the answer is **best investing strategy is to invest early!**

**How does Compounding benefit me?**

As mentioned previously compounding is when interest is earned on top of interest.

Example: You have an investment of $1000 that pays 10% interest

1

^{st}payment: $100 ($1000 X 0.1)2

^{nd}payment: $110 ($1100 X 0.1)3

^{rd}payment: $121 ($1210 X 0.1)4

^{th}payment: $133.1 ($1331 X 0.1)

Did you notice how the *interest *increased over time? That’s because the interest payment is added back to the principle and the new interest payment is calculated on the new amount, hence compounding the interest.

The above example is fairly simple and is intend to explain the concept of compounding interest, let’s take a look at the real life impact of compounding. I have made a compounding spreadsheet, that can calculate compounding interest over a long period of time, in this calculator I have included five scenarios. You can download the compounding calculator and plug-in your numbers and try different cases, for now we’ll look at the following cases.

We have five individuals with different investment strategies; let’s see who has the best investment strategy.

**George**: Invests $2000/yr consistently for 20 years, he stops contributing after 20 years, and let’s compounding do the work.

**Frank**: Frank is a little slow so he starts investing 20 years AFTER George, he consistently invests $2000/yr for 20 years.

**Lisa**: Lisa, like George, invests the $2000/year consistently but unlike George she contributes for 40 years.

**Toni**: Toni missed the first 2 years, but after that he invests $2000/year for the next 38 years.

**Rebeca**: Rebeca has a different style, she skips the first 20 years, but then contributes DOUBLE the amount ($4000/year) for the next 20 years.

Forty years into the future and let’s see who’s investment strategy was the best:

George value: $317K Total invested: $40K

Frank value: $82K Total invested: $40k

Lisa value: $399K Total invested: $80K

Toni value: $345K Total invested: $76K

Rebecca value: $163K Total invested; $80K

Let’s skip the obvious results and look at a couple more interesting outcomes.

Lisa and Rebecca both invested $80K, but look at Lisa’s portfolio is more than double Rebecca’s portfolio. They both invested $80K, so why would Lisa’s portfolio be worth much more? That is the power of compounding!

For an even more staggering comparison let’s look at the following case:

**Lisa vs Toni: Lisa only invested $4000 (5%) more than Toni did, but her portfolio is worth $54K (15%) more than Toni’s, why? The Magic of Compounding.**

Do not underestimate the power of compounding interest, best investment strategy is to invest early.

Download the Compounding Excel Sheet.

**What are your thoughts on compounding interest? **

See I find people know and believe in compounding interest but they miss a couple of things about it. Yes it is a great and powerful thing. People tend to forget equity returns. Through in a down year and it tends to mess up a nice compound interest curve. Now through in 2008 returns and see what happens. Does it hurt?

@ EW Yes years like 2008 hurt, but investors need to focus on the long term returns rather than just a single year. Yes I know 2008 wiped out about 10 years of equity returns but after every down market there is a bull market.

So you loose 60% of the value. You do realize you need to get a 150% rate of return just to get to where you were. That’s one hell of a bull market. If it’s wiping out 10 years of returns, is it a good way to estimate future values? Financial planners all the time use compound interest curves to show growth of investments without regard to the way in which equities fluctuate. It’s scary to me that people are misinformed into a false sense of security about the future of their money. How does it make you feel?

By the way which 10 years does it wipe out on a compound interest curve?

loose 60% of your value? If you lost 60% of your portfolio while the market lost about 40% than you are obviously doing something very wrong. Financial planners use compounded interest and ignore market fluctuations because nobody knows exactly how much it will fluctuate, just as there are bad years like last year, there will be good years you can not possibly take all of that into account when trying to estimate your growth. So you take an average usually 6-8% (yes we’ll have years with -20% but we’ll also have years with 20%) that is the best way one can estimate growth. That is why it is important for investors to educate themselves and ask questions, nobody can control the markets all you can control is your emotions. Although markets are down for the past 10 years, if you look back long term say 20 years we S&P is still up over 200% since august 1989, this includes 3 bear markets.

If someone is scared of losing money in the markets and maybe they should stay away from it, eventually inflation will eat away purchasing power.

The market lost 40% in the calendar year of 2008. If you go from the market close on Jan 3rd 2008 of 1447 to market close of Mar 9th 2009 of 678, you get a drop of about 55%. If you use intraday it gets worse. So yes the S&P 500 lost nearly 60% of it’s value. Just so you know if you gain 20% one year and lose 20% the next year you aren’t even. You are still down 4% without even taking into account inflation. That puts you pretty far off from 6-8% every year.

I do have two questions however,

1. Is the only way to combat inflation using the market? So are people helpless without the market?

2. If financial planners ingnore the unknown (market fluctuations) as you say, wouldn’t that be setting people up for failure? There must be a better way, right? Or is praying for no fluctuations the way to succeed?

PS – if i’m bothering you let me know and I’ll go away.

You make a great point why you should do it and how it benefits you. But the key is showing people how to do early so they can benefit from compounding. The easiest and simplest way to do it is through a retirement plan where you are making regular contributions. If you automate the process, you can really benefit from compounding.

@EW 1. You are no bother.

Maybe you keep missing the point, I said financial planners, and pretty much everyone in the investment world uses a AVERAGE expected rate of return and often this number is between 6-8% yes so we did have a bad year, but we also have had good years and will have them again. Again forget just one year look back on S&P 500 over the past 20 or 30 years (long term investing) over the past 20 years S&P AVERAGED over 10% with an annualized return of over 8% and in the past 30 years AVERAGED 12% with an annualized return of 11%. These include 3 bear markets and including the tech bubble and the recent bear market. So even though people lost 40% or more in each of those bear markets the market still returned an AVERAGE of over 8%.

Thanks for the mention. As I noted in my post, calculations such as thing almost always overstate the effect of compounding because inflation is also compounding and working against the investor.

I would never advocate not saving early. However, IMO, it also makes sense, perhaps more so, to pay down all debt first. People start out their financial lives under massive amounts of debt — mortgage debt, student loans etc. Paying this down provides a high, guaranteed, after-tax rate of return — often times, better than what stocks can provide.

I understand what you are saying about averages. You are right about averages. My question is are averages the best way to do financial planning? Are they accurate for future growth? Or are you setting people up for financial failure?

In a lot larger scheme, can you use this simple math on/with money. My opinion/point/face (whichever you choose to call it) is that you can’t. That math is not money. I wrote a post in July about it here: http://evolutionofwealth.com/2009/07/29/money-is-not-math/

I use your average annual rates of return over 20 years and it fails at predicting actual values in accounts. I look forward to hearing your thoughts/criticisms.

PS – I hope you are enjoying this conversation as much as I am.

I would say that the average 401k (allocated 60% stocks/ 40% bonds) probably lost around 25% in 2008. And while the average US annual return captured the US moving from an emerging market to the most powerful nation on earth, it did also capture the Great Depression, the 70’s bear market and the tech crash, and still provided 10% returns.

A portfolio allocated between the major asset classes and rebalanced periodically, should still provide a reasonable rate of return over every 30-40 year period. And that is not even taking into account active strategies.

great page – was just thinking about this concept and wanted to review it – compounding is extremely powerful tool even when the market is down – being diversified helps a bit

Where can I invest for compound interest safely? I invested with Bulow Funds and they stole my money. I used Liberty Reserve for an internation transaction. I did not recover a dime. Claire

“Example: You have an investment of $1000 that pays 10% interest”

Where do I sign up for 10% interest..?

I understand the value of compound interest. It’s a great thing, if one can get an interest rate worth a darn.

But I’m really tired of example after example being posted online showing regular folks getting annual rates of 7-10%.

Sure, it illustrates the value of compound interest. But this isn’t 1983 here. The best CD rate I can currently find is still under 2%.

So, while using high interest rates is a good way to show the effect of compounding, the examples are so unrealistic as to be near worthless.

That is a good point Barbara, however we are not talking CD rates here but long term equity returns. I used 10% to make things easier, but 8% return is reasonable for a diversified portfolio over the long term.

“8% return is reasonable for a diversified portfolio” is not interest.

Describing how a diversified portfolio might grow over time is not describing the effect of compound interest.

Entirely different matters.

Again point is not INTEREST, it is to show the power of compound. I don’t want to run and explain a Monte Carlo simulation and how different asset classes can play out under different assumptions etc. Portfolio construction, analysis and management is a fairly complicated matter. The point is very simple, start investing early.

Just because one cannot get a 10% interest on their savings account does not mean one cannot benefit from compounding. The “analysis” relates to long term portfolios and not your daily savings account.

Oh you can benefit from compounding…you will get $50 in a year from the current interest rates (0.00% – 1.95%). It’s not really a benefit, it’s actually a loss because you can be using your money in a better investment.

wouldn’t investing in a drip plan (a dividend reivestment plan) in a ROTH IRA instrument eventually achieve the compounding( in the number of shares) you are looking to achieve? If it’s not subject to capital gains taxes, income taxes or even transactions fees on the reinvestments, it is going to compound pretty well after 25 – 30 years right? What is wrong with this approach?

actually there is a lot of investment out there that are giving 7 % – 10% average with a guarantee of 1% interest if the market crash like 2008. If you are really interested send me an email thanks.