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Improving Financial Literacy: The Power of Compounding

Tuesday, February 17 2015 12:00am

Albert Einstein called the power of compounding the eighth wonder of the world.

Tags: Finance

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By Harry Greenfield
Glidden Visiting Professor

YOUR WALLET — Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.  Using compounding to your advantage can generate significant rewards for investors who invest early.

As I previously noted, after you know the purpose of budgeting and how to budget, the first thing that you should do in a budget is pay yourself.  Paying yourself and putting that money into savings and investments, will yield huge benefits as the graph above shows.

An example of how compounding is beneficial, financial planners like to tell the story of identical twins.  An 18-year-old girl, Pat, puts $2,000 into an account each year from the ages of 19-25, then stops contributing and lets it compound at a rate of 10% until age 65.  Her twin brother, Bob, is not as disciplined and continues to blow his money on useless things. Finally, at age 26, he realizes he needs to start saving, too.  Bob puts $2,000 per year into his account starting at age 26. He also lets his money compound at a rate of 10% until age 65. 
 
Because of compounding, by age 65, Pat is almost a millionaire, with $944,641 in her account.  By age 65, Bob is almost a millionaire, too, with $973,074 in his account.  The difference is, Pat has contributed only $14,000 in total, while Bob has contributed $80,000 in total — more than five times what his sister has contributed.  By starting early, Pat has been able to secure her retirement and investing 17.5% of what her brother did to obtain the same goal.
 
Looking at it another way, if you invest $361.04 a month at the age of 20 into a retirement fund and continue until you are 65 and you are able to obtain a 6% return, at 65 you would have $1,000,000.  If you do not start saving until you are 40, you would have to invest $1435.83 a month to obtain the same result.
 
The moral of the story, invest early (invest NOW!) and continue to invest. You are doing yourself a large favor.