Let Asset Compounding Be Your Best Employee

Growing wealth, especially as you’re just starting out, can sometimes seem like a fruitless task. Every month, quarter, year, you make contributions, however, the movement of the markets is only modestly impacting your account balance. Not only that, you are foregoing current consumption, which can be difficult in your earlier years especially if you are not seeing significant results from your investments. 

Saving and investing is of course important to plan for a myriad of personal goals for later in your life. Saving early in your career, and as aggressively as you can, will allow the power of compounding to work to its fullest extent, making your money work for you, as opposed to you working for your money. Think of compounding as you hiring your own money to work for you for the rest of your life. Albert Einstein is often attributed to the claim that compounding is the “8th wonder of the world”, so let us see why.

Take this simple example. Let’s assume a long 40 year time horizon (start investing when you’re 22), a balanced investment strategy earning 5% per year, with contributions of $2,400 at the beginning of each year. For the sake of example, we will ignore inflation impacts, and will address in a future post.

With these assumptions, in your first year, you’ve contributed $2,400, and at a 5% earning rate, that equates to a $120 gain. A seemingly small amount considering the many enjoyable things you could do with $2,400 as a 22 year old. Your account balance is now $2,520.

The next year, you again contribute $2,400. This year, you have made $246 though. Notice that this is not simply $120 X 2. It is $120 X 2, plus an additional $6. Where did that extra $6 come from? That $6 came from the fact that you not only have your contributions working for you, but you have your contributions plus your gains working for you. You get paid 5% on the additional $120 you made in year 1. That is the extra $6. That is compounding.

Now an extra $6 a year from compounding may again sound like a meaningless endeavor. However, consider that as time goes on, the amount of your account balance growth that comes from contributions is steady, while your compounding gains grow further each year. For example, by year 10, your gains from contributions are $1,200, and compounding gains are $309. By year 27, your contribution gains and your compounding gains are equal at about $3,300 each. By year 40, when you’re hopefully approaching retirement, your gains from contributions are $4,800, while your gains from compounding are almost $9,700 per year, double your gains from contributions. That $9,700/annum and growing in gains is the long term result of that initial $6 growth from year 1. That is a powerful result, from a simple and reasonable savings plan, and how sticking with a plan can make your money work for you over and over again throughout your lifetime.

Many think of compounding like growing a tree. You plant a seed, water it, give it sunlight, stare at it every day, and nothing happens. Then one day finally a sprout appears, giving you some hope, but still a fairly small result. You continue to care for it, and see slow and steady growth through the years. In one year down the road, the amount of care you need to provide is less than the growth of what is now a strong and robust tree. Eventually, its growth far surpasses any care you need to provide, growing strongly on its own, all a result of your early and consistent investment in its success.