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The Power of Compounding

For those of you who don't already know about and use it, the concept of compound interest is totally amazing! A simplified version of how it works goes like this. You start an investment with a financial institution by putting money into an account, and then you get paid interest on the money in the account. At the end of the year, your account total is the amount you started the account with, plus the interest earned. During the next year interest is paid to you on the account total including the interest you earned during the first year as well as on your initial investment. And so it continues through the years. My father-in-law used to describe it as, "earning interest on top of interest earned", which is a little convoluted, but coveys the notion.

Now, when you think about it for a minute, you can easily see how important the factor of time becomes. If you only leave the money invested for a very few years, compounding will still work for you, but it won't work the magic it can work over many years. The longer the time frame, the more powerful compounding becomes.  I'll try and make this point with an illustration.

We'll make an investment of $2,400; which we could accumulate by saving $200 per month for one year.  It'll be a "one-time" investment, meaning we won't add any more money from our paycheck. We will assume an average return rate of ten percent, which you won't get in a savings account, but can get with stock market investments. We will let the $2,400 work for us for forty years, and then watch it grow.

• At the end of a short investment time frame, say three years, we would have $3,194 dollars in the account. We've made $794, which isn't that much, but compounding is working for us. (We'll compare the last three years with this first three in a couple of minutes.)
• At the end of eight years, we have $5,144, and that is a little more than double our original investment. A handy fact to remember is this, at a ten percent return rate, an investment doubles in seven and a half years.
• At ten years, our account total is $6,224, at twenty years it's $16,145, at thirty we have $41,878; and at forty years the account total is $108,622. In the 39th year, the account earned $9,875.
• In comparison to the first three year earnings of $794, during the last three years we earned $27,013.

That, then, is the power of compounding. In the illustration, our tiny $2,400 grew to a huge $108,622 because the money was given time to grow, and it grew A LOT in the last few years. The initial investment was small enough so it probably wouldn't have affected our life style greatly, but the final total certainly IS enough to influence our retirement life style wonderfully well.

One additional comment might be worth making here. For money you are investing for the long term, it is important to leave it alone and let it work for you. Don't treat your retirement investment accounts like you might treat your regular savings account. You don't want to withdraw retirement investment money for things like buying a car, or taking the family on a vacation no matter how great a time you expect to have.

If you want to explore similar illustrations of the power of compounding using different return rates and adding annual contributions using your calculator, pen, and paper it's relatively easy but takes some time. Here's how. Enter a starting investment figure > hit the M + key > hit Mrc key. There's your initial investment figure. Next, >hit the X key, enter your chosen return rate in decimal form > hit the = key > hit M+ > hit Mrc. There's your "account" total after one year. Now enter your next annual contribution, hit the M+ key; then do the return rate routine again and your total at the end of the second year will show. Repeat the process going as many years forward as you like. Hint: be sure to write down each year's total, else you might find yourself saying bad words from time to time.

If you happen to have Windows XP on your computer you can find "future value" a lot easier. Open your spread sheet. Enter the following into one of the cells: @FV(Pmt,Rate,Nper) The @ tells your computer what you're going to do. FV means "future value", which is what you're after. The parentheses tells your computer to do the math contained within them.. "Pmt" stand for the regular contributions you plan to make. "Rate" is for the projected return rate you're using, and it must be in decimal form: for example, ten percent would be shown as .1; eight percent would be .08, and so on. "Nper" stands for the number of periods during which you will make contributions. For example, if you want to do a 20 year study, you would enter 20. The commas tell your computer to multiply, so you can't use commas in showing figures because the computer reads commas as multiplication signs. Also, the amount you enter for your annual contribution must be in "numeric" format, which means no dollar signs and no commas. Further, the answer will also be in "numeric" format, meaning no commas or dollar signs. (Check the example below related to the last three sentences.)

Now you replace the letters in the formula with figures. If you wanted to do a study with a $2400 annual contribution at a return rate of eight percent and a 20 year time frame, the final formula would look like this; @FV(2400,.08,20)

Next, click outside the cell containing the formula, and the future value total will appear in the cell, and the formula disappears. Let's see what we get with the above formula.

• @FV(2400,.08,20) = 109828.7; which translates to $109,828.70.

So, you can test different possible scenarios using different contributions, different return rates, and different time frames. It can be an interesting-even inspiring-exercise to do because you may see possibilities for your future that you didn't see before. I'll leave you with the following thoughts:

• If our tiny $2,400 grew that much in the first illustration, imagine what would've happened if we had invested the same amount every year during the same time frame.
• Better still, what if we figured out how to save and invest ten percent, or twenty percent of the earnings from our job?

arley