What is Compounding?
Compounding is the financial equivalent of a snowball rolling downhill: With each revolution the snowball gets bigger because it picks up more snow.
Compounding can produce a snowball effect with money, that’s what happens when your earnings generate even more earnings. Each year’s potential earnings on your investment can contribute a little more to earnings the following year. As time passes, earnings can contribute more and more to the total value of an investment.
The basics of compounding
As an introduction to compounding, let’s look at its impact on a hypothetical $15,000 lump-sum investment that earns 4% interest per year.
|Year||Value||4% Interest||Interest Earnings Increase
from Prior Year
For illustrative purposes only; assumes all interest is reinvested. The concept of compounding is presented by using a hypothetical investment and is not intended to represent or predict the performance of any Franklin Templeton fund.
These numbers may not seem like much to crow about, but notice that even though the interest rate stays the same, the amount earned through interest increases each year.
A long-term investor could see the value increase more and more with each passing year. That’s because as the interest rate is applied to a larger amount each year, it generates a greater amount of interest.
Now that we understand the nuts and bolts of the math, let’s look at how this same example plays out over a longer time frame. By reinvesting the 4% annual interest for 30 years, the $15,000 hypothetical investment could have more than tripled in value, to $48,651 at the end of the period.
Reinvest earnings and put your money to work. You may have noticed that our hypothetical example assumes the interest payment is never taken in cash. Reinvesting the interest increases the value of the investment which, in turn, increases the amount of interest earned each year. As time passes, interest on the reinvested interest could rival or even surpass the interest generated from the initial investment alone.
Earnings Can Dwarf the Initial Investment Over Time
Hypothetical illustration of long-term effects of compounding
Assumptions: $15,000 initial investment and 4% annual interest with all interest reinvested. For illustrative purposes only; does not represent or predict the performance of any Franklin Templeton fund.
The effects of compounding really stand out if you consider what happens when the interest is not reinvested. If you took the earnings in cash each year from our hypothetical investment earning 4% annual interest, you’d receive $600 per year (or a total of $18,000) over 30 years.
On the other hand, if you reinvested the interest each year, it would generate an additional $15,561 in interest on top of the $18,000 generated by the initial investment over those 30 years.
Growth on top of compounding. For simplicity, we’ve used a hypothetical investment that earns an annual interest rate of 4% to understand the basics of compounding. In our example above, we assume that principal and interest do not vary. But for most mutual funds, these elements do naturally vary with market conditions.
So what’s the impact of compounding on different kinds of mutual funds — for example, funds that include growth as a goal but have share prices that fluctuate according to market movements?
The basic principles of compounding apply to any mutual fund. Namely, reinvesting earnings (dividends and capital gains) over time can lead to potentially large increases in value.
If a fund’s share price rises, your initial investment grows independently of the effects of compounding. Although there’s no guarantee that a fund’s share price will increase, coupling this kind of growth potential with compounding has been an effective strategy for many long-term investors.
The Rewards of Starting To Invest Now
It’s easy for investing to get lumped into the list of things you’ll eventually get around to. But the impact of time on an investment makes getting started right now a wise move. To put the power of compounding on your side, you’ll need to give it time to do its work.
To see how getting started right now can pay off, let’s consider a hypothetical situation in which two friends named Rachel and Sarah start investing at different times.
Rachel starts now. Rachel starts investing $100 each month. After 10 years of regular monthly investments, she buys a house and needs that $100 to make the mortgage payment. She stops adding to her investments, but she doesn’t touch her account until she retires 30 years later.
Sarah starts later. Ten years later, Sarah realizes she doesn’t have any retirement savings and decides to start investing. She invests $100 every month until she retires 30 years later.
Starting Early Can Reward Investors
Assumptions: 8% average annual return; all earnings reinvested; no fluctuation of principal. For illustrative purposes only. Not intended to be representative of the past or future performance of any Franklin Templeton fund.
Rachel comes out ahead. Sarah contributed to her investments for 30 years; Rachel for only 10. Sarah contributed a total of $36,000; Rachel invested only $12,000. So, how can it be that Rachel has accumulated more money than Sarah?
One word: Compounding
That’s the secret behind the growth of Rachel’s nest egg. And when money grows as a result of compounding, time is a major influence on that growth. As time passes, the effects of compounding increase. By starting 10 years earlier than Sarah, Rachel gave her investment more time to benefit from the effects of compounding.
A good lesson for kids. If the story of Rachel and Sarah was an eye-opener, imagine the potential impact on an investment for somebody with even more years ahead — like a teenager.
For example, let’s say 15-year-old Luke makes $1,000 mowing lawns one summer. And with some encouragement from his parents, he invests the money instead of spending it.
After 50 years of compounding. While Luke’s been busy living, his $1,000 investment has been chugging along at an average annual return of 8% with all earnings reinvested. After 50 years, when Luke is ready to retire, his $1,000 has grown to $53,878. (The example is for illustration only and doesn’t predict or represent the performance of any Franklin Templeton fund.)
This lesson can be a powerful one for kids. If you’re a parent, teaching your kids about compounding and encouraging them to get started right away with investing could be the greatest gift you ever give them.
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