Compounding: why time is your friend

Highlights

  • Compounding is the snowball effect that occurs when investments are reinvested over time.
  • The effects of compounding over many years can be tremendous.


Compounding is the “magic” that happens when you save and invest money over many years. It can be tricky to understand because the numbers grow bigger than you might initially expect. Simply put, compounding is the snowball effect that occurs when your money is reinvested over time – that is, when the interest from a bank account or return from an investment account keeps getting added to your balance. Compounding is what makes your money work hard. It’s also the reason why it pays to start saving as soon as possible, because the longer your money is invested, the more time the snowball has to grow. Here’s how it works.

What's the big deal about starting early?

When it comes to compounding, a few years can make a huge difference. Let’s say you start saving $3,000 a year for your retirement at age 25. You try to talk your friend into doing the same thing, but she decides to wait a few years. “I’ve got plenty of time,” she says. That may be the case, but it turns out your friend is going to have more time than money, while you’re on track to hit the half-a-million-dollar mark. Have a look at each of your balances assuming you both earn 6% on your money.
 

Age You Your Friend
25 $3,000 0
26 $6,551 0
27 $10,124 0
28 $13,911 0
29 $17,926 0
30 $22,182 0
31 $26,692 0
32 $31,474 $3,000
33 $36,542 $6,551
34 $41,915 $10,124
35 $47,610 $13,911
40 $81,639 $36,542
45 $127,177 $66,828
50 $188,117 $107,357
55 $269,670 $161,594
60 $378,804 $234,175
65 $524,852 $331,304
 
There are two interesting things to notice. The first is that, in the first seven years, before your friend even starts to save, you’ve built up over $30,000. How did that happen? You were only saving $3,000 per year, so you might have expected the total to be closer to $21,000 (7 x $3,000). The difference is due to compounding, since, with each passing year, you have more and more money in your account that can continue to grow.
 
The second thing is how much larger your nest egg is than your friend’s. In fact, it’s almost $200,000 bigger even though you only saved for seven more years than the 33 years (33 years!) that your friend saved.
 
Congratulations, you’ve just proven the power of compounding!

How does compounding happen?

There are three necessary ingredients for compounding to occur. The bigger each of these items is, the larger your financial snowball will end up being.

  1. The amount of money you save or invest (the snow)
  2. The percentage interest or return you earn (the snow that builds up as it rolls downhill)
  3. The length of time you allow your money to be reinvested (how far your snowball has to roll)

Is this why you hear about starting early for retirement?

Yes. Funding your retirement takes many years of saving. The sooner you start, the greater the chance that you’ll meet your goal. Plenty of people play catch-up; we’re not saying that it’s impossible. It just means you have to save a lot more every year.

How do I know what my return will be?

You don’t – which is another reason to start early since you’ll give your savings more time to ride out the inevitable zigs and zags of the financial markets. It’s easy to get spooked when the stock market declines, but when looked at over decades, the stock market has been amazingly resilient.

“Sometimes the stock market really tests my nerves, but I try to be patient and ignore the daily stock updates and instead focus on the long term.” – Lauren, 30

What if I need to use some of that money?

Unfortunately, if you knock some of the snow off your snowball, you’re going to seriously slow down the compounding process. To the extent possible, try not to interrupt your money while it’s hard at work.

How much should I save?

That depends on your goals and financial situation, but we think that at least 5% of your income is a good starting point. If you’re nearing retirement and feel a little behind, you may need to save more. Depending on how much time you have, here’s a general idea of how much your retirement fund could grow if you save $500 per month.
 
How might my savings grow if I can save $500 a month?
 

 
Return on my investment
 
 
Balance
In 10 years
 
Balance
In 20 years
 
Balance
In 30 years
 
Balance
In 40 years
 
1%
 
$63,000
 
$133,000
 
$210,000
 
$295,000
 
3%
 
$70,000
 
$164,000
 
$290,000
 
$460,000
 
5%
 
$77,000
 
$204,000
 
$409,000
 
$744,000
 
7%
 
$86,000
 
$255,000
 
$588,000
 
$1,243,000
 
10%
 
$101,000
 
$362,000
 
$1,040,000
 
$2,800,000
 
12%
 
$112,000
 
$460,000
 
$1,540,000
 
$4,900,000
Assumes 6% return and adjustment for inflation.
 
“When I first started participating in my company’s 401k plan, I thought that balance would never go up. Now, after a few years, it’s amazing how it’s grown.” – Alan, 32

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