Compounding is the process of generating more return on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. Compound interest can help your initial investment grow exponentially. For younger investors, it is the greatest investing tool possible, and the #1 argument for starting as early as possible. Below we give a couple of examples of compound interest.
Example #1: Apple stock
An investment of $10,000 in the stock of Apple (AAPL) that was made on December 31, 1980 would have grown to $2,709,248 as of the market’s close on February 28, 2017 according to Morningstar’s Advisor Workstation tool. This translates to an annual return of 16.75%, including the reinvestment of all dividends from the stock.
Apple started paying dividends in 2012. Even so, if those dividends hadn’t been reinvested the ending balance of this investment would have been $2,247,949 or 83% of the amount that you would have had by reinvesting.
While Apple of one of the most successful companies, and their stock is a winner year-in and year-out, compound interest also works for index funds, which which are managed to replicate the performance of a major market index such as the S&P 500.
Example #2: Vanguard 500 Index
Another example of the benefits of compounding is the popular Vanguard 500 Index fund (VFINX) held for the 20 years ending February 28, 2017.
A $10,000 investment into the fund made on February 28, 1997 would have grown to a value of $42,650 at the end of the 20-year period. This assumes the reinvestment of all fund distributions for dividends, interest or capital gains back into the fund.
Without reinvesting the distributions, the value of the initial $10,000 investment would have grown to $29,548 or 69% of the amount with reinvestment.
In this and the Apple example, current year taxes would have been due on any fund distributions or stock dividends if the investment was held in a taxable account, but for most investors, these earnings can grow tax-deferred in a retirement account such as a employer-sponsored 401(k).
Another way to look at the power of compounding is to compare how much less initial investment you need if you start early to reach the same goal.
A 25-year-old who wishes to accumulate $1 million by age 60 would need to invest $880.21 each month assuming a constant return of 5%.
A 35-year-old wishing to accumulate $1 million by age 60 would need to invest $1,679.23 each month using the same assumptions.
A 45-year-old would need to invest $3,741.27 each month to accumulate the same $1 million by age 60. That’s almost 4 times the amount that the 25-year old needs. Starting early is especially helpful when saving for retirement, when putting aside a little bit early in your career can reap great benefits.
No one investing strategy or approach fits all. Every investor has different reasons for investing, different goals, different time horizons and varying degrees of comfort with investing. It’s important to define and articulate your own parameters.
What are your objectives for the money that you will be investing? Is safety of principal with some level of return sufficient? Are you trying to accumulate money for a longer-term goal such as a college education for your kids or perhaps a comfortable retirement for yourself?
You might even have different investments for different goals. The point is that before you decide to invest any money it is important to understand why you are investing and the end result that you are seeking.
Goals and objectives should not be created in a vacuum. You also need to know your risk tolerance and time horizon as part of the goal-setting process.
Risk can mean a lot of things, but in the context of investing it means the risk of losing money. In other words, the risk that the amount of money invested will decrease in value, possibly to zero.
All investing involves risk in one way or another. Stocks can and often do go down in value over certain periods of time—in 2008, the S&P 500 dropped by 37%. While this decline in the stock market was one of the worst in history, less severe market corrections are not uncommon.
How much of a drop in value for your investments can you stomach? Your risk tolerance will likely be in part a function of when you need the money—known as your time horizon—which is usually a function of age. Someone in their 20s or 30s who is saving for retirement shouldn’t give too much thought to fluctuations in the value—known as the volatility—of their investments.
In contrast, someone in their 60s likely will and should have a lower risk tolerance if for no other reason than they don’t have the time to fully recoup a major loss in the value of their investments.
Your investments should be aligned with the time horizon in which you will need the money, especially if some or all of your investments are targeted for a specific goal.
For example, if you are young parents investing for your newborn’s college education, your long time horizon allows you to take a bit more risk in the initial years. When your kid gets to high school, you might adjust the investment mix to help ensure that you don’t suffer any major losses in the years leading up to the start of college.
How long will you stay in one particular investment? Legendary investor Warren Buffett rarely sells a stock he owns and doesn’t get rattled by market fluctuations. This is generally known as a “buy-and-hold” strategy.
At the other extreme are traders who buy and sell stocks on a daily basis. This is fine for professionals, but rarely a good idea for the average investor.
Nobody is advocating that your need to hold an investment forever, and in fact things change and you should be reviewing your individual holdings periodically to ensure they are still appropriate for your situation.
Knowledge and comfort
Some investment vehicles require sophisticated knowledge and monitoring, while others are more set-and-forget. Your investment decisions should be based on your comfort level and your willingness to devote time to researching your choices.
An easy route is to choose a variety of low-cost index funds that cover various parts of the markets such as bonds, domestic stocks and foreign stocks. Another alternative to consider are professionally managed vehicles such as target date mutual funds, where the manager allocates portfolio over time. These funds are designed to gradually reduce their exposure to equities as the target date of the fund gets closer
Investors with more knowledge and experience might consider actively managed mutual funds, individual stocks, real estate or other alternative investments.
Understand what you don’t know
It is important that investors understand what they do and don’t know. They should never be talked into investing in something that they don’t understand or are uncomfortable with.