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What is “compounding” and why is it so great? It sounds like such a fancy financial term. One can think of compounding as a snowball rolling down a hill – the longer the snowball rolls (or the higher up the mountain you begin), the more compounding will expand the size of your snowball. Expanding your investment portfolio through compounding should be your major goal.
Albert Einstein, arguably one of the most intelligent people to walk this planet, was asked to describe mankind's greatest discovery. His answer: "compound interest." He went so far as to call it one of the "Eight Wonders of the World." The benefits of compounding can be demonstrated via famous explorer, Christopher Columbus.
We all know the story, "In 1492, Christopher Columbus sailed the ocean blue." To emphasize the benefits of compounding, let us suppose that Christopher Columbus made an investment in the historic year of 1492. If Chris had placed a single penny in a 6% interest-bearing account and instructed someone to remove the interest every year and put it in a piggybank, the total value collected in that piggybank would eventually accumulate to more than 30 cents. A pretty nice multiplier-effect on one penny, but not too much absolute cold hard cash to write home about...agreed?
However, if the young explorer had placed the same paltry investment of one cent into the same interest-bearing account, but left the remaining earned interest to compound (thereby earning interest upon the previously earned interest) the results would be drastically different.
What would you guess the compounded account would be worth in 2009?
$10,000? $100,000? $1 million? $10 million? $100 million?
“NO” is the correct answer to all these guesses.
The correct answer: $121,096,709,346.21! Your eyes do not deceive you. That one penny invested in 1492 would have grown to $121 billion dollars today. If you don’t believe me, pull out your calculator and multiply $.01 by 1.06%, and repeat 517 times. Surely, we will not live 517 years to collect on an investment of such long duration. However, with proper planning everyone has the ability to invest quite a bit more than one cent to significantly build future wealth.
As an adviser, the problems related to compounding I see investors commit most are two-fold:
- Investors are constantly shifting money in and out of their accounts (usually at suboptimal points) due to apprehension and greed, thereby nullifying the benefits of compounding.
- Because of overpowering fear relating to current economic conditions, investors are parking their money in low yielding CDs (Certificates of Deposit), savings accounts, checking accounts, money market accounts, or other low returning investment vehicles. This strategy is equivalent to pushing the aforementioned snowball over the sidewalk, rather than down a long, steep hill.
In order to reap the rewards of compounding and dramatically expand your investment portfolio, a systematic, disciplined approach to investing needs to be followed. A system that more likely than not has a 20 year horizon rather than 20 days. Now go start saving those pennies!
More Resources:
Wade W. Slome, CFA, CFP® has worked in the investment industry since 1993, and Bloomberg identified him as the second youngest manager among the largest 25 actively-managed U.S. mutual funds in 2005. Mr. Slome has also been a media go-to resource, seen on ABC News and quoted in USA Today, The New York Times, Dow Jones, Investor's Business Daily, Bloomberg, and Smart Money, among other publications. He is also publisher of investment blog, InvestingCaffeine.com.
Prior to founding Sidoxia Capital Management (www.Sidoxia.com), Mr. Slome managed a multi-billion mutual fund at American Century Investments from October 2002 through August 2007.
Mr. Slome earned a master’s degree in business administration with a concentration in finance from Cornell University and a bachelor’s degree in economics from the University of California, Los Angeles.
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I agree. Many people underestimate the value of compound interest. Chump change can grow to be quite the nest egg if invested correctly.
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Investing / Saving is like rolling a snowball down a hill. The earlier you start saving, the larger your snowball will be at the bottom of the hill (i.e., retirement).
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It's important to point out the difference between savings and investment. Savings generally refer to holding onto something without losing it, investment is expecting to make money from something with the risk of losing it (Robert Kessler). Our current economic situations highlight the importance of this. Compounding works great as long as you dont lose the penny that you initially have. Experts who stress on the importance of investing often I feel are filled with greed and self interest (they often use the terms savings and investment to their convienence).Hope we first learn to save and then invest understanding the risks involved, compounding then works truly great!
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Bensunn:
Good points - these last two years have shown that investing is certainly not a risk-free endeavor. However, stuffing money under the mattress earning next to nothing is not going to help a vast majority of people reach their financial goals. Exploding healthcare costs, a bankrupt social security system, climbing food, energy, and leisure costs make prudent risk taking essential for longer-term time horizons. Add the fact that life expectancies are increasing significantly, and one realizes we need our savings to work efficiently for us.
I agree with you that many investors/savers took on more risk than they were aware of. People should create a portfolio and investment plan that synchs with their risk tolerance.
For the risk averse, they will either need to save more to combat inflation, or work longer before retiring. For the vast majority, prudent assumption of risk will lead to a higher after-tax return in the long run.
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Who does this type of savings plan?
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Bethany:
There are fewer and fewer advisors and fund managers that invest for the long-run. Due to the advances in technology (dramatically lower trading costs) and the speed of information flow accelerated by the internet, investors are owning securities for shorter and shorter timeframes.
However, there are advisors, like myself, who are focused on long-term, low cost, tax-efficient savings products and strategies. You just need to do your homework and ask tough questions if you are considering a new advisor.
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That is true everything boils down to risk management, which is quite subjective...is it risky to invest or is it risky not to invest?what are the consequences? and what do the consequences mean to each of us? definitely we all have things to learn from the experts, but choosing experts by itself is an art, after the recent breach of trust for most of us the easiest way is to save more and invest passively, or one should think pretty hard before turning to an expert...
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Anne Rice touched upon the accumulation of wealth by vampires who had incredibly long lives and tended to not be involved in day trading. But seriously if people do stop thinking in terms of days or months or years and started thinking as endowments do, then they may have better results.
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Wade W. Slome, CFA, CFP replied 2 months ago
I agree. There is a reason Warren Buffett became the wealthiest person on this planet, and it wasn't short-term thinking.
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