The physicist Albert Einstein apocryphally said that "compound interest is the most powerful force in the universe." Whether or not the quote is real, the sentiment remains intriguing – and it has powerful implications for your investment strategy.
Interest isn’t the only thing that compounds – whenever gains are reinvested, the principle of compounding gains applies. The math here is simple, though it gets more complicated with more sophisticated investments.
Let’s say that your initial investment totals $20,000 and that after dividends are reinvested, you are earning a fairly unremarkable 5 percent annual return on your investment.
After five years, that $10,000 will have become $25,525. Over ten years, it will become $32,577; over 20 years, $53,065. Compounding explains why investing when you’re young is such a powerful strategy – returns become more valuable every year.
If at the end of every year you added $1,000, after 20 years you’d have over $85,000 for an investment of just $40,000.
In addition, reinvesting dividends has tax benefits – because you don’t have to pay taxes on reinvested dividend payments – and most brokers will do it automatically at no charge.