How compounding can work for you

With any investment one of the big questions asked is, "How quickly will my money grow?" This is understandable because the main reason to invest is the hope to see an eventual profit. Whether you are investing for retirement, higher education or a new home, having an idea of how quickly your investments may grow can be an important aspect of your decision making process.

One of the ways an investment in mutual funds may grow is through compounding. This occurs when earnings are reinvested in the fund. As your income or dividends are reinvested, more shares are purchased, which may in turn provide additional income and dividends. In other words, your income from the fund earns its own income, and so on. This is the power of compounding.

You may not notice the affects of compounding during the early stages of your investment, but it can gain momentum as the earnings begin to accumulate. There is a simple calculation you can use to see how soon your investment may double. It is called the Rule of 72.

To use the rule of 72, you must determine the estimated rate of return for your investment. The number of years needed for your investment to double can be found by dividing 72 by that estimated rate. For example, if you have an investment in a bond mutual fund that averages a 5% rate of return, your investment may double in 14.4 years (72/5 = 14.4). Money invested in a fund with an estimated return of 9% may double in eight years (72/9 = 8).

As an example, take a look at the chart below. The chart assumes a $1,000 investment at the beginning of the first year earning a 6% return. Numbers have been rounded to the nearest dollar. For simplicity, we will assume there was no more money invested. The chart is a hypothetical example and does not represent any investment currently available. The following results do not reflect a tax rate nor do they reflect fees and expenses that apply to professionally managed securities.

This hypothetical chart is for illustrative purposes only and is not intended to represent or imply the actual performance of any specific investment. It is important to note that any investment involves risks that may result in the loss of principal and there is no guarantee that the strategies illustrated will produce positive investment results.

As you can see, compounding made a modest difference in the ending balances during the early years of this investment. However, as more earnings were added, the power of compounding made a significant impact over time.

The rule of 72 can be an important rule to remember as you decide what your investment goals are and the length of time you are willing to devote to your investment. You can get an idea of what an investment's average returns are by looking at how well it has performed previously. Unfortunately, past performance doesn't guarantee future results.

You should also keep in mind that a higher rate of return usually means a higher risk is involved. Some investments may have high returns one year but provide less than expected returns the next. The returns used in the example are hypothetical and do not represent returns of any fund. Investment return and principal value will fluctuate and your investment, when redeemed, may be worth more or less than its original cost.     

It is important to note that there is market risk involved when investing in mutual funds, including possible loss of principal.

State Farm VP Management Corp Risk/Important Disclosures. State Farm Mutual Funds Prospectus. The State Farm College Savings Plan Enrollment Handbook (PDF 276 KB).

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