In our previous Retirement for Beginners blog post, we illustrated the difference between saving money under your mattress or in a piggy bank and investing for retirement. The key takeaway was that if you just save money, it doesn’t grow over time (and actually loses value due to inflation), but if you invest, you’ll benefit from the power of compounding.
In personal finance, many people refer to “the miracle of compound interest” or “the magic of compounding.” This is because compounding leads to exponential growth of your assets. You can start to see the magic of compounding in the following example.
If you have $10,000 saved in a bank account with a 0% interest rate, in 10 years it will still be $10,000. However, if you put those funds in a high yield savings account at a 3% interest rate, even if you do not contribute any more to that account, it will be worth $13,493 in 10 years. This is because it is earning 3% interest on the original amount, the amount of interest earned is being added to the balance each month, and then it is earning 3% interest on the total amount in subsequent months.
When we invest, the money grows for a few different reasons. One is that, hopefully, the value of your assets (usually stock and bonds), will grow over time. It is difficult to predict how much an individual company’s stock will grow over time, but we do know that the average rate of growth of the stock market as a whole has historically been about 7%, even when accounting for recessions and depressions. In addition, when you own stocks and bonds you are also paid out dividends, which are distributions of a company’s earnings to its shareholders. These are usually distributed monthly or quarterly, and if you reinvest them, you buy more shares, which will in turn increase in value and earn dividends over time.
So, if we take our $10,000 from above and invest it in a total stock market index fund that can reasonably be expected to grow at the average rate of the stock market, 7%, we can see the power of compounding in action in a big way. After 10 years, even if no other contributions are made, that $10,000 can grow to $20,136.
This illustrates why we always recommend that you start investing for retirement as early as possible. This way time will do the heavy lifting, which means less scrimping and saving.
Of course, continuing to invest over time will have the most powerful impact on your retirement investments. If you had your $10,000 invested and then contributed $100 per month, you’d have $37,405 in 10 years. If you contributed $500 per month, which is the equivalent to maxing out a Roth IRA each year, you’d have $106,639 in 10 years.
Another way to visualize this is by looking at the retirement account balances at age 65, based on the starting age of the investor, and the amount saved monthly, from this article at The Motley Fool.
Retirement for Beginners (Part 2): Power of Compound Interest is written by Terri Bennett, A Certified Financial Trainer for financialgym.com