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January 19, 2014

The power of compounding

Compound growth, also known as exponential growth, is one of the most powerful yet least understood forces in personal finance. Even a basic understanding of how it works and its effects on building personal wealth could motivate investors of all ages to make smarter saving and investing decisions, especially in the area of retirement planning.

It’s no surprise that research on people’s ability to estimate the effects of compounding on their savings has consistently found that even sophisticated consumers dramatically underestimate its wealth building potential. Conceptualizing and calculating the effect of exponential growth on savings when regular contributions are made to an account is neither intuitive nor simple. Nevertheless, this calculation is fundamental to making the kinds of important financial decisions that Americans face every day.

The best way to demonstrate how compounding works is by example. For the sake of simplicity, we will ignore the effect of inflation. Consider a 25-year-old investor just getting started in her career. She begins saving and investing a fixed amount of $10,000 at the end of each year toward her retirement in a portfolio that earns 5 percent annually after tax. She reinvests those earnings at the end of each year in the portfolio and allows them to grow untouched. Upon reaching age 65, after 40 years of growth, the account would be worth almost $1.3 million.

The principal variables that influence the compound growth of an investment are the amount the investor saves, the rate of return earned on the assets and the period of time the investments are allowed to grow untouched. Even relatively small variations in these factors can have outsized effects on the ability to build wealth. Let’s see how changes in our underlying assumptions influence the results.

Contribution amounts: Spending less than you earn and saving and investing the rest is the basis for building wealth. If our investor decided to increase her contributions by 6 percent each year (e.g. $10,000 in year 1, $10,600 in year 2, $11,236 in year 3, etc.), from pay raises and promotions, she can more than double her retirement account balance at age 65 to over $3.4 million. For most people with even modest career trajectories, increasing savings by 6 percent annually is a reasonable goal. Establishing and adhering to a disciplined and automatic saving and investing program is the key to accomplishing this.

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