‘The Eighth Wonder of the World’
Albert Einstein reportedly described compounding as “the eighth wonder of the world.” It is one of the most important concepts in investing.
To understand how compounding works, assume you invest $200 and earn 10% in each of the next two years. After the first year, you’ll end up with $220. Your $200 will have earned 10%, or $20. The next year, you won’t just earn another $20; you’ll earn $22. That’s because your original $200 will have earned 10% and so will the $20 you earned last year. That might not seem like a very big deal, but over time, the power of compounding can turn a little bit of money into a lot.
For example, let’s say a 20-year-old investor named Claire invested $200 per month, kept at it for 50 years, and generated an average annual return of 7%1. At age 70, she will have invested $120,000. But because of her 7% average annual return, the power of compounding will have turned her $120,000 into nearly $1.1 million!
How to Maximize Compounding
The keys to Claire’s success:
• Consistent investing
• A good rate of return
• Time
As the Bible says,
All three keys are important: Investing a portion of every dollar you earn, generating a good rate of return, and giving it time.
In Session 4, you’ll learn how to figure out how much you should invest each month to meet your retirement goals.
1. As we just saw, the long-term average annual return of the U.S. stock market has been 10%. We’re using 7% in this example because it would be wise for Claire to make her portfolio less aggressive as she gets older (For example, moving from 100% stocks to 80% stocks/20% bonds and then 60% stocks/40% bonds), which would lower her potential returns