Compounding interest title

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Power of compounding
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The Power of Compounding Interest
August 2004

Einstein called the power of compounding the eighth wonder of the world. It certainly is amazing and you can use it to build your wealth.

Compounding works when you earn a return on your return.

This means, if you earned 10% in 1 year on $1,000, at the end of that year you would have $1,100. The second year, you earn another 10%, but now you have $1,100 to start that year. After the second year, you have $1,210. That's $10 more than the prior year. Basically, you start to earn interest on your interest.

The power of compounding depends on how much you invest, the rate of your investment return and the amount of time you have.

Let's take a simple example to illustrate this concept. If you were to start with a penny and double it each day, how much would you have after 30 days? The first day you start with just 1 penny. The second day you double that and have 2 cents. The 3rd day you would double the 2 cents and have 4 cents. After 10 days you would have a whopping $5.12. Not much yet, right? But if you keep doubling the prior day's amount ever day for 30 days you would have $5,368,709.12

That's right! Over 5 million dollars!

Here is how my example shakes out over the entire 30 days:

Day 1
.01
Day 2
.02
Day 3
.04
Day 4
.08
Day 5
.16
Day 6
.32
Day 7
.64
Day 8
1.28
Day 9
2.56
Day 10
5.12
Day 11
10.24
Day 12
20.48
Day 13
40.96
Day 14
81.92
Day 15
163.84
Day 16
327.68
Day 17
655.36
Day 18
1,310.72
Day 19
2,621.44
Day 20
5,242.88
Day 21
10,485.76
Day 22
20,971.52
Day 23
41,943.04
Day 24
83,886.08
Day 25
167,772.16
Day 26
335,544.32
Day 27
671,088.64
Day 28
1,342,177.28
Day 29
2,684,354.56
Day 30
5,368,709.12


Look at what happened in the last 10 days! The numbers start accelerating. I know this is an extreme example, but I just wanted to demonstrate the power of compounding. Instead of 30 days, this could be a more reasonable timespan of 30 years. Also, here we are earning 100% a day, which is nearly impossible, especially when your money grows into the huge sums illustrated. You would be hard pressed to earn 100% a year.

Historically, stocks have returned about 10% a year.

But the power of compounding still applies. What if you could save $2,000 a year and earn 10% over 30 years? Well, you would have $361,886! If you were to save $5,000 a year and earn the same 10% every year, you would have $904,717!

The key to the power of compounding is to start early.

It might seem like it is not working in the beginning. it might seem boring those first few years, but if you stick to your financial game plan, you will have a solid financial future.

When you are saving for retirement it is important to maximize the power of compounding. These examples, though simple to illustrate my point, assume that you are reinvesting your returns every year. If you are not saving for retirement in a retirement account, such as an IRA or 401K, you are going to have to pay Uncle Sam taxes on your capital gains and/or interest every year! This can drastically reduce your returns.

What I want you to understand from this brief newsletter is that the power of compounding can secure your financial future if you start now, start early and save every month and every year!

This is something you can do right now by opening a mutual fund or brokerage account using automatic investments, without a large deposit. You can open automatic investment accounts for as little as $25 a month! I have a Sharebuilder account that invests in stocks of my choice for only $4 a month, on the first Tuesday of each month.

Let the power of compounding work for you!

Power of compounding interest footer

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