The Power of Compounding

You may have heard of compound interest.  It sounds like a fancy term but what does it mean and how can you make it work for you?  In the context of financial independence, compounding is arguably the most important aid in that journey.

Looking at the formula above, there are a number of variables, but they key ones are (time) and r (interest rate).  Those two variables will drive your portfolio.


Let’s start with an example: You have $1,000 today and you invest in a stock index that offers an 8% annual return historically.  Assuming the index could earn 8% next year, your $1,000 would effectively turn into $1,080. In year 2, assuming you reinvest that $1,080 and the stock index again returns 8%, you would have roughly $1,166.  If you repeat this exercise, your $1,000 will turn into $2,160 by the end of year 10, effectively doubling your initial $1,000.

For someone with a long time horizon, such as a new college graduate who is investing his first pay cheque, over the course of the next 40 years, for every $1,000 he invests, it could turn into $21,700 in 40 years assuming the average stock market return of 8%.

So the first rule of compounding is to start early!  The second rule is do it often, which means continually adding to your investments as much as you can, so you can let both TIME and INTEREST RATE work for you.

As usual, if you have any questions, Ask the Fellow!


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