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January 12, 2014

Understanding compound growth

When planning their financial futures the number one goal that comes to mind for most people is retirement. Even for those who love their jobs and plan to work as long as possible, the time will come when they will leave the workforce and rely on their savings to help support a comfortable lifestyle.

In order to build a retirement nest egg that can last three decades or longer, most investors will need to adopt a disciplined program of saving a portion of their working income and allow those savings to grow. Most individuals accept the idea of sacrificing a little today to avoid living an unreasonably frugal lifestyle in their later years.

The accelerating trend of companies replacing pension plans that pay retirees a monthly benefit for life with 401(k)-type plans has shifted the responsibility of saving aggressively and investing wisely squarely onto the individual. To fulfill this responsibility a basic understanding of personal finance is essential.

One of the most important but least understood concepts in personal finance is compound growth, often referred to as compound interest.

Compound growth occurs when an investment is allowed to grow so that earnings are generated not only on the contributions made into an account but also on the earnings of those contributions. In other words, the investment earnings themselves generate earnings and are left to grow in the account. This creates an effect similar to a snowball rolling down a hill. Like the snowball that grows faster as it picks up more snow, an investor’s account balance grows faster as the years roll on because all interest, dividends and capital gains distributions that are reinvested also generate earnings. The results can be so dramatic they may be difficult to comprehend. Simple growth on the other hand is when the increase in the account value for each period (i.e. month, year, etc.) is a constant amount and is based only on the amount of contributions.

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