I wish I had learned about the power of compounding a long time ago. As a kid I walked dogs in the neighborhood, earning $5 a week. If I'd started investing that weekly $5 from age nine until 65, it would have grown to $254,000, assuming an 8 percent return.
Unfortunately, I didn't catch compounding fever until much later. Because money was tight when I was starting my career, I missed out on maximizing my first few years of 401(k) contributions, which would have made a huge difference at retirement.
But on a positive note, my 11-year-old son learned from my mistakes and socks away his $10 weekly newspaper delivery salary, which he earns in addition to his allowance. My wife and I sweeten the pot by matching his savings in an IRA we opened for him. I suspect my daughter will follow suit when she's old enough to get a part-time job.
So what is compounding? Basically, it's where you put aside money -- whether in savings, a retirement account or the stock market -- and then essentially leave it alone. As your account earns interest or dividends, you continually reinvest those profits, thereby generating (compounding) additional earnings at an accelerated rate.
Numerous interactive calculators are available online to help you estimate potential savings under different scenarios. I used several from Dinkytown in the following examples, but similar tools are located on financial and investment sites across the Web. (It's worth noting that although the 8 percent interest yield I use in the examples below may seem high in today's market, historically the S&P 500 Index has experienced a 9.5 percent annualized return over the last 100 years.)
How investments grow over time. Using the Compound Interest and Your Return calculator, you can estimate how quickly a one-time investment will grow at varying interest rates and periods of time. For example, a $10,000 investment earning 8 percent compounded quarterly would be worth $22,080 after 10 years; $48,754 after 20 years; and $107,652 after 30 years.
Escalating impact of regular monthly savings. If you can set money aside every month, your savings will grow even faster. According to the Cool Million calculator, if you began saving $100 a month at age 21 and earned 8 percent interest, by 65 your account would be worth about $447,000. Increasing the monthly contribution to $200 would double that to about $893,000. And, by saving $300 a month, you'd reach $1 million by age 61.
Interest rates matter. The riskier the investment, the greater your potential gains -- and losses. For example, regular savings accounts typically offer very low interest rates in exchange for very low risk of loss. On the other hand, investing in the stock market can potentially earn double-digit investment rates over long periods of time. Of course, stocks can be a risky short-term investment, as we've seen in the past few years.
So why not simply park your money in a safe haven? Simple: inflation. If your money is earning 2 percent interest but the inflation rate is 3 percent, you'll actually net a 1 percent loss.
Using the Cool Million $100-a-month example above, if you expect to earn 8 percent interest but factor in a 3.1 percent expected annual inflation rate (the overall average rate since 1925), your account balance at age 65 would be worth more like $117,000 in today's dollars, versus the $447,000 amount unadjusted for inflation. Furthermore, by reducing the expected annual interest rate to only 4 percent, your account balance would drop to around $141,000 -- or only $37,000 after adjusting for inflation.
Postponing savings can hurt. The longer you delay saving, the harder it is to catch up. According to the Don't Delay Your Savings! calculator, if you save $200 a month at 8 percent interest, after 30 years your account would be worth $283,522. But wait only two years to begin saving and that balance would shrink to only $238,612 -- that's $44,910 less. A five-year delay would knock it down to only $182,968.
A good financial advisor can help you devise a well-diversified investment strategy that will help you balance your appetite for risk with methods to beat inflation. If you don't already have a financial planner, the Financial Planning Association is a good place to start your search.
To watch easy-to-follow videos showing how compound interest works, as explained by a mathematician from the renowned Khan Academy, visit Practical Money Skills for Life, a free personal financial management program run by my employer, Visa Inc.
Bottom line: Don't procrastinate on starting to save. And get your kids on the compounding bandwagon as well; they'll thank you once they reach your age.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.
To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney
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