If you’re like most people, you need your investments to grow to achieve the life you want. Fortunately, there’s a deceptively simple but exceptionally powerful tool that can help you produce that growth. It’s called compounding, and it’s the process of earning investment returns on your past investment returns. Compound returns are such a big deal that they have been called the eighth wonder of the world.
The Wonders of Compounding
What puts compounding on par with the Great Pyramid at Giza? It can help your portfolio grow exponentially over time. Take this simplified (very) hypothetical example:
- You invest $10,000 and earn a 10% return the first year. In this example, your returns compound annually, so by the end of the year you have an additional $1,000.
- Now you have a total of $11,000. You keep it invested and earn another 10% return the next year.
- Since you started with more money, your 10% return produces a larger gain in dollar terms than it did the first year: $1,100 rather than $1,000.
The more your investments grow, the more you can reinvest in pursuit of more growth.
You can pull a couple key levers to make the most of compounding. Using them wisely could give your savings a considerable boost. Let’s take a look:
Give It Time
In investing, time makes it possible for wealth to snowball. The longer you can allow your investment returns to compound, the greater the snowballing effect can be.
Thanks to compounding, money you invest early can become much more valuable than money you invest later in life. Many investors already get this on an intuitive level. But it can help to understand a numerical curiosity that explains why compounding works so well:
Consider the following simplified example:
Investor 1, age 30, invests $10,000 dollars at the beginning of the year for 10 years and earns a 7% annual return. At the end of the decade, they have contributed $100,000. At that point they stop making contributions and leave their money to keep earning 7% annually.
Total portfolio value at age 65: $802,370
Investor 2, age 40, is trying to catch up. They invest $10,000 a year at the beginning of the year for 25 years, and they also earn a 7% annual return. Their total contributions add up to $250,000. Their portfolio’s value at age 65 is about $125,000 less than Investor 1’s, even though they contributed $150,000 more.
Total portfolio value at age 65: $676,765
The upshot: The earlier you can start investing and taking advantage of compounding, the better.
Make the Most of Tax Advantages
Taxes sap compounding’s strength. If you hold investments in a taxable account, their interest payouts, dividends and realized capital gains can trigger taxes that effectively reduce your annual return. Lower effective returns leave less money to grow the next year.
It’s a different story if you hold your portfolio in a tax-advantaged account such as a 401(k), traditional IRA or Roth IRA. You don’t pay taxes on money while it’s in these accounts, so every dollar of gains can go to work for you.
That’s not to say you won’t pay taxes eventually. You contribute pre-tax money to traditional 401(k)s and IRAs, and it can grow tax-deferred while in the accounts. When you withdraw money after age 59 ½, the money you take out will be taxed at normal income tax rates. In the meantime, however, tax-advantaged compounding can help you build a considerably larger nest egg.
Roth accounts, on the other hand, are funded with after-tax dollars. Money inside the accounts grows tax-free, and you don’t pay taxes on withdrawals made after age 59 ½. In essence, any compound investment growth in a Roth is tax-free.
The upshot: Investing inside tax-advantaged accounts can help your portfolio grow faster by preserving more of any growth for longer.
Control What You Can
Like most things in life, investing includes many elements you can’t control, so it’s essential to focus on what you can—especially those moves that help you make the most of compounding. That’s why starting early, staying invested for the long term and capitalizing on tax-advantaged accounts are critical for investing toward your long-term goals.
