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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

1st payment: \$100 (\$1000 X 0.1)

2nd payment: \$110 (\$1100 X 0.1)

3rd payment: \$121 (\$1210 X 0.1)

4th 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.

What are your thoughts on compounding interest?

Ray

Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.