Never Interrupt Compounding!
Often times dubbed as the eight wonder of the world, compounding, is a force you should never mess with. People think that achieving great returns in the stock market is all you need to build wealth. And while the type of returns you achieve certainly matters, what can matter more is not interrupting compounding.
Investing $100,000 and leaving it alone for 20 years, earning an average return of 10% per year, would grow to roughly $672,750. That’s 6.7 times your original investment from a very minimal initial effort, and a great deal of patience. Coming up with $100,000 is a different story, but this multiple holds true for whatever amount you start with.
Think about this. Had you instead invested the same amount, $100,000, but each year you took the earned gains and spent them. What type of average annual return do you think you’d need to earn to generate the same amount of money as in the first example ($672,750) over a 20 year period?
If you guessed roughly 30% you’d be correct (28.63% to be exact). Yes, that’s right, you’d need to generate nearly 3 times the return!
This is the power of compounding!
And all you need to do to benefit from compounding is invest your money and stay out of the way!
What you invest in really depends on your age, your goals and your risk disposition. If you don’t know anything about investing and you don’t care to learn, but you can wait a few decades, you can’t go wrong with a low cost S&P 500 index fund.
Compounding Takes Forever to Work
You may have heard that it takes a long time to see the benefits of compounding. That may be true, depending on how you view the benefits of compounding. It actually starts working for you the moment you invest your first dollar, and it NEVER stops working, unless of course you take your money out of the market.
It’s true that the stock market doesn’t always go up, there are pullbacks, corrections and crashes. And if you intend on being invested for a longer period of time, odds are you’re going to experience a handful of these market events. Data still suggests that if you leave your capital invested for at least a decade, the odds of losing money are minimal.
Most investors practice a style of investing called dollar cost averaging (DCA). This is the type of investing where you periodically add more money to your portfolio. The vast majority of us do not have large sums of money that we can drop into the market at a single point in time.
Let me show you how long it takes for compounding to “work” with DCA.
Let’s say you can afford to invest $250 each month, for a total of $3,000 per year.
If you can achieve a 10% return per year (long term market average).
In the first year you’d earn $167.57.
And of this $167.57 how much do you this is attributable directly to the power of compounding?
If you guessed $5.07, you would be correct!
I realize that may not sound like much, only 3.03% of your gain in the first year is directly through compound returns.
If you continued this DCA strategy in year 2 and contributed another $3,000 ($250 each month).
Your gains in year 2 would be $499.26.
This time the amount of this return that is directly earned through compounding is $36.76 or 7.36%.
Still not a meaningful amount. But you’ll notice that the effect of compounding more than doubled from the prior year in terms of the percentage impact on your total return.
Let’s fast forward to year #5.
At the end of the fifth year, you’d have invested a total of $15,000. Your gain in year #5 would be $1,717.63.
$355.13 of the fifth year’s gain is a direct result of compounding, that’s 20.68% of this year’s return. More than a 5th of your return in the fifth year is through the power of compounding.
Let’s again skip forward to year #8.
By the end of the eight year the total amount you would have invested would be $24,000. Your gain in year eight would be $3,360.23.
You’ll notice that your invested capital has earned you more money this year than you actually contributed. At this point your portfolio is growing faster through market returns than your contributions.
Of the $3,360.23 return in year eight, $1,097.73 is a direct result of compounding, that’s 32.67% of your return!
Let’s skip ahead to year #12.
By the end of the twelfth year you would have invested $36,000 into this portfolio. Your gain in year twelve would be $6,472.63.
In this year your market gains are more than twice as large as your contributions for the year!
Of the $6,472.63 gain, $3,010.13 is directly due to compounding!
Compounding has finally matched your annual contributions! And it accounted for 46.51% of your gains this year!
While compounding does start off slow it gains steam each and every year, and its a blast to watch it work.
If you could follow this strategy for a full 20 years, the total amount you would have invested would be $60,000.
Your gain in year 20 would be $18,011.96!
$12,149.46 of this gain is directly the result of compounding, that’s more than 67%!
After 30 years your total investment would be $90,000.
Your gain in year 30 would be $53,880.25!
And $45,017.75 of this gain is directly through the power of compounding! That’s 83.55%!
And if you start early in life and can keep this DCA investing strategy up for 40 years.
Your total investment would be $120,000.
Your gain in year 40 would be $150,977.20!
$139,114.70 of this gain is directly tied to compounding!
At this point your $250 monthly contributions are almost insignificant compared to the effect of compounding!
There comes a point in a DCA investing strategy where your portfolio starts to earn more money each year than you actually need! When this happens you have essentially reached financial freedom.
Here’s a visual to paint the impact of compounding a little better.
You’ll notice how compounding starts off small but gains momentum each year. And it very quickly takes over, earning you more money than your actual invested capital!
Here’s a visual comparing your monthly contribution against monthly market returns for 15 years.
The takeaway from this visual is that your contributions matter a lot early on in your investing journey. However somewhere around the 8th year, the returns you generate from the market start to surpass your contributions. And this all feeds into the compounding snowball.
Here’s the same visual but for a 40 year period this time, again showing monthly data. You’ll notice how insignificant your contributions are at the later stages of this investing journey.
The moral of the story is that you want to extend your investing horizon for as long as possible and you want to get as much capital invested as early as you can to get this compounding machine going.