The topic of compound interest is a powerful investment concept that is essential for any personal investment strategy. Compounding can help you to slowly and steadily achieve your investment and retirement goals. Compound interest, or more commonly called “compounding” is defined by Wikipedia:
In a simple example, compound interest, or compounding your investments can be accomplished by seeding an investment account and allowing that investment account to grow over an extended period of time without withdrawing any funds. Over time, your investment will most likely generate capital gains, interest or dividend payments from your initial investment of capital. Here’s the essential part of compounding your investments: You must reinvest those new returns back into your investment strategy and allow that new cash work for you. When you do this, you will see your total invested capital grow slightly, and now your investment base is slightly larger than it was before. The reinvestment of returns over time can help your investment account to grow at an incremental rate.
To enhance the compounding of your investments, you should consider setting up a recurring investment each month into your investment accounts. The key to compounding is to allow any and all money to remain within the investment account and to reinvest any cash received back into your investment strategy.
To further this example, if you set up an investment account with $100,000 and it grows annually at 5% over 25 years, the total will grow to $339,000. In addition, if you also contribute $200 per month using the same example, your investment will grow to $453,000.
If you increase your expected return on your investments from 5% to 8%, you can start to see substantial growth in your returns over the same 25 year period. By slightly changing the assumption of growth rate from 5% to 8% and keeping the $200 per month contribution and an initial investment of $100,000 you will see your investments grow to approximately $860,000.
So what are the key tenets of compounding your investments:
- Invest consistently - Develop an investment plan that you can adhere to over the investment horizon.
- Reinvest - As most investment accounts generate cash over time, it is essential to allow your money to remain invested and allow your earnings to reinvest back into the investment strategy.
- Tithe to yourself - Set aside as much as you comfortably can each month to bolster your investment and savings accounts.
- Limit Withdrawals - Your investment account has the best chance of performing well if you avoid taking funds out of it. Allow your money to grow and also allow any interest or dividends to remain invested inside of your investment account.
- What if you fall off the horse? - Like all things in life, it’s hard to remain consistent for multiple decades. For example, over a 25 year period real people may find challenges in contributing a consistent amount, and it’s hard to commit to never withdrawing funds from your investment accounts. What’s important here is the concept, and staying dedicated to the concept of investing for the long term, staying consistent and committed to your investments.
Individual investors should be aware of compounding as a key concept to implement and consider during the planning phase of an investment strategy. You can visit Investor.gov to use their compounding calculator.