I recently saw an interesting video that asked a number of regular people if they would rather have a million dollars now or take a penny now and double the amount every day for the next 30 days. As expected, 90% of people chose the million dollars now option. I would have made this choice myself a few years ago. But this would have been the poorer choice, because you would have short changed yourself by over $4 million at the end of the 30 day period. Don’t believe me? Look at penny table calculation on the right. The simple act of doubling your previous day’s investment can rapidly reap huge rewards thanks to the powerful concept known as compounding.
Now a 100% return every day is highly unlikely, but the principle of compounding holds true for even smaller returns (though it will take longer than a month to make your fortune). This is why compounding is a core aspect of good personal finance and the reason why the rich get richer. Basically it comes down to age old tenet – when you’re young, you have an asset money can’t buy: TIME. Start saving now and turn pocket change into riches.
Compound interest has been called the eighth wonder of the world. And with good reason. It magically turns a little bit of money, invested wisely, into a whole lot of cash. Even Albert Einstein is said to have called it one of the greatest mathematical concepts of our time.
But you don’t need to be a genius to harness the power of compound interest. Even the most average of Joes can use it to make money, without having to know the theory of relativity.
Here’s the gist which you can clearly see in the penny table. When you save or invest, your money earns interest, or appreciates. The next year, you earn interest on your original money and the interest from the first year. In the third year, you earn interest on your original money and the interest from the first two years. And so on. It’s like a snowball effect – roll it down a snowy hill and it’ll build on itself to get bigger and bigger before you know it.
To make compounding work for you follow these three basic principles:
1. The sooner you start, the better. Compounding is a function of the return you get and time. For most people a 3 to 7 percent is realistic, but time is a diminishing commodity. So the younger you are, the more time you have to really make compounding work for you, and the wealthier you can become. The next best thing to starting early is starting now. Consider this example: Amy, a 22-year-old university graduate, saves $300 per month into an account earning 10% per year for 6 years. Then at age 28, she starts a family and decides to stay home with the children full time. By then, Amy had kicked in $21,600 of her own money. But even if she doesn’t contribute another cent ever, her money would grow to a million bucks by the time she turned 65!
2. Make regular investments. Especially via a tax advantaged 401K or IRA plan or in a good high yield savings account for your post-tax savings. Remain disciplined, and make saving a priority. The more you save, the more you can let compounding work its magic. Even a little bit goes a long way, and you can start with as little as $20 a month.
3. Be patient. Compounding only works if you allow your investment (capital) to grow. It takes time to see the wonders of compounding returns, and as you can see in the penny table the most growth comes at the very end. Compounding creates a snowball of money and you will get rich if you start young, invest wisely and leave your money alone over the long term.