Are you ready for a secret? Pay attention and you can learn one of the keys to successful long-term investing. It’s not difficult to understand, complicated to put to work, or tricky to maintain. Better still, this secret works while you sleep – and eat and work and play and go through all of the routines of a typical day.
So what’s the mysterious recipe for long-term investing? It’s the miracle of compound returns.
The Basics of Compounding
Compounding isn’t difficult to understand. You probably learned about compound interest when you were a kid. When you put money in the bank, you earn interest on your savings. The next month, you earn interest on the interest as well as on your original contribution. Over a year, the effective interest rate you earn on your money is even larger than the monthly rate advertised by the bank – as long as you don’t withdraw the monthly interest but let it keep working for you in your account.
Compounding also works in your investment account. Your stocks and funds can generate income from capital gains, dividends and distributions. When you keep that income in your account, reinvested in purchases of additional shares of stocks or index shares, your earnings generate additional earnings – and you reap the rewards of compound returns.*
Growth by Leaps and Bounds
But here’s the kicker. Over the period of many years, the returns you get from compounding will eventually outpace your initial contributions. That’s right, as your investment account grows, even small, regular contributions can grow to become a formidable sum. See the chart for an illustration of how just $50 a month can grow from the effects of compounding – and pay attention to the rapid increase in growth that comes after many, many years of investing.
Chart Disclaimer: *Hypothetical illustration for presentation purposes only. Actual investment experience will vary with stock selection and changing market conditions.
Over 30 years, $50 a month adds up to $18,000. At a 4 percent annual return, your $18,000 will grow to $34,868, while an 8% return will give you $75,064. If you’re fortunate enough to earn a 12 percent return, your money can grow to become $176,545 – all with that same $18,000 in monthly $50 contributions (based on fixed rates of return). Compounding is a powerful tool to help you build wealth*.
See these figures working live in our compound interest calculator.
Don’t Spend Your Earnings!
Of course, compounding only works if you don’t spend your earnings as you receive them, but reinvest all of those returns back into your account. You’ll never get rich if you end up spending your profits along the way!
The effects of compounding are difficult to see in the short term, but don’t let that deter you. The final lesson about the miracle of compounding is that time matters – so don’t delay in starting your own investing plan. After all, the miracle is yours only if you choose to let it work for you.
*Of course, compounding does not assure an overall profit or positive return in an investment account, as stocks and reinvested dividends are subject to market fluctuation and changing economic conditions.