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Investment Basics

The Power of Compounding

Compounding is often referred to as the “miracle” of the investing world. That is because investing even a small amount of money and keeping it invested over a long period of time has the potential to make it grow exponentially into a relative fortune.

Compounding, or earning interest on interest, is best described by an ancient story.

A Maharaja ruled the Indus Valley, in northern India, in the sixth century. Bored, he asked his court gamesman to develop a new game for him. The gamesman created chaturanga, the army game, the precursor of chess and played on a board of sixty-four squares. The Maharaja was delighted and asked the gamesman what he would like as a reward.

"Nothing much," answered the gamesman, "Just one single grain of wheat on the first square, two grains on the second, four on the third, eight on the fourth, and so on across the board."

In calculating the gamesman's reward, the Maharaja discovered that, even before he was half-way across the board, he owed the gamesman more grains of wheat than existed in all of India. He solved his problem by ordering the gamesman executed.

The gamesman was earning interest at the rate of 100% per square, far beyond what we can expect. However, the principle of compounding interest remains the same. Earning interest on interest can add up over the long term.

Suppose you have a mutual fund which performs at the rate of 8% per year. If you invest $1000 annually, and leave all your money in the fund, after twenty-five years you will have $73,110. If you invest $10,000 annually, after twenty-five years you will have $731,100.

Investing for the long term and reinvesting the earnings pays off. The annual performance makes a great deal of difference, too. If our mutual fund earned 10% rather than 8%, our twenty-five year nest egg would swell to $ 983,500. A gain of $252,400 with the same annual investment, but a 2% higher rate of return.

The two most important factors in compounding, therefore, are time and rate of return. The power of compounding leads to some general rules in investing:

  • Don't let funds accumulate without earning interest. The money in your mattress, and in a non-interest-bearing bank account, is earning 0% per year. When you factor in inflation, you are losing money every year at the rate of inflation.
  • Whatever your investment, make regular deposits. If you skip a single $100 per year investment at 12%, after twenty-five years you have lost $13,333 less.
  • Look for investments that pay the highest rate of return without the risk of losing sleep at night. Small differences in return add up over the years.
  • Arrange for at least several month's salary to be liquid, cashable at any time in case of emergencies such as job loss. Even a 15% return on your investment over twenty-five years may not be worthwhile if you have to pay a huge penalty for cashing in early.
  • Every dollar you owe in credit card balances, personal and car loans, and mortgages is a dollar you are not investing. Pay off your after-tax loans as soon as possible to free your money up to work for you, not your creditors.
  • Ask your investment advisor how to best make the power of compounding work for you, based on your financial picture and the amount of money you have to invest. There are many alternatives with differing risks and rates of return, and an investment adviser can help you make the best choice.
The more money you save and invest today, the more you'll have in the future. Real wealth, the stuff of dreams, is in fact created almost magically through the most mundane and commonplace principles: patience, time, and the power of compounding.

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