This is a guest post from Pauline of InvestmentZen.com
When it comes to building a strong financial future, time is the most powerful commodity you have at your disposal. Investing early allows you to benefit from compounding year after year. This is why those who start investing at a younger age are looking at a much bigger nest egg than those who start when they’re older. Let’s take a look at the power of investing early in action.
What is Compounding?
The concept of compounding is simple to understand without being an expert in investing. It’s the idea that your returns will generate their own returns if they are reinvested. If that didn’t make any sense to you look at this example.
Let’s say you open a brokerage account and start making a 5% return on your investments every year for five years. You take out what you gain every year, though. So, if you start with $1,000, you will make $50 every year. If you withdraw this $50 every year, you will earn $250 over the course of the five years.
Now let’s take a look at someone who leaves their investments where they are and reinvest the dividends, or interests. They allow compounding to take place. They still start investing with the same $1,000 and get the same 5% return every year for five years. Compounding will give them $276 because the $50 worth of interest will generate interest the next year, and so on.
It might seem like a small difference, but with larger amounts, regular deposits, and longer periods, compounding can turn out to be quite significant.
How Do People Take Advantage of Compounding?
Remember that investing is a long-term strategy. Taking full advantage of compounding means you need to be prepared to leave your investments and not touch them for twenty or thirty years. You also need to keep adding to it. For this example, we’re going to take someone who invests over a thirty-year period using an aggressive strategy of deposits.
This person starts off with $5,000 when they turn 21. They immediately invest it and earn a solid average 7.5% return every year. That is nothing extraordinary, since the S&P500 has returned over 8% on average for the past 30 years. The difference is they’re saving aggressively, so they’re able to add $1,000 to this fund every single month. So, over a thirty-year period how much can they expect to have when they turn 51?
Their nest egg will be worth $1.3 million. And only $365,000 of that came from the deposits they made and the initial $5,000 starting capital. $969,000 came from the gains they made over time.
That is how powerful compound interest is. Since you are investing regularly, you should only invest money you are ready to lock for the mid to long term. Withdrawing early can have big repercussions over the final amount of your nest egg. Moreover, some brokers will charge you a fee every time you buy or sell. That can cripple your returns too.
So stick with a low fee robo-advisor, such as Motif, Tradeking, Betterment or Wealthfront. If you don’t know much about investing, stick to index funds, and keep your eyes on the long term prize. Markets will go up and down, and you won’t beat them even if you try. Most fund managers can’t. Try not to be emotional and keep adding to your account every month.
Why Starting Young Can Make a Huge Difference
Now you can see how compounding makes such a big difference. The other major point you need to know about compounding is that its true value is in time. Starting an investing venture when you’re 20 is much different from starting when you’re 40.
Person A is 20. He starts investing with $10,000. He gets a 5% return per year. Every month he invests $1,000 from his salary. By the time, he retires at age 65, with the power of compounding, he can expect a return of just over $2 million, with only $550,000 of that coming from money he’s actually poured in.
Person B is 40. He also starts with $10,000 and puts in $1,000 per month at an average 5% return per year. At age 65 he can expect $621,000, of which $310,000 comes from money he put in directly.
As you can see, starting early is the key to benefitting from the power of compounding. And the higher the returns, the more powerful compounding is.
You don’t need to have a lot of money to start investing. Even $500 is enough to get started. A small amount with dividends reinvested constantly can set you up for a comfortable retirement. Not sure? Have a look at retirement and compound interest calculators to see how much $100 a month can turn into over the next 35 years.
How old are you and when do you plan on getting started with investing?