Compounding investment returns
Whether you're investing for retirement, higher education, or a new home, knowing how quickly your investments may grow will help your decision-making process. Reinvesting, or compounding, your earnings can make a big difference in your investment account's growth.
What is compounding?
Compounding occurs when you reinvest your earnings and/or dividends in the fund. You may not see the benefits of compounding right away but account growth can gain momentum as earnings begin to accumulate.
How the rule of 72 works
- Find the estimated rate of return for 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.
- Divide 72 by your estimated rate of return. For example, money invested in a fund with an estimated return of 6% may double in 12 years (72/6 = 12).
Using the Rule of 72, the chart below shows you how compounding might play out over a 20-year period with a $1,000 investment. We used a 6% estimated rate of return.
Years invested and ending balance
| Hypothetical Illustration | ||
|---|---|---|
| Year 1- $1,060 | Year 11- $2,011 | Year 21- $3,603 |
| Year 2- $1,124 | Year 12- $2,132 | Year 22- $3,819 |
| Year 3- $1,191 | Year 13- $2,260 | Year 23- $4,048 |
| Year 4- $1,262 | Year 14- $2,396 | Year 24- $4,291 |
| Year 5- $1,418 | Year 15- $2,540 | Year 25- $4,548 |
| Year 6- $1,503 | Year 16- $2,692 | Year 26- $4,821 |
| Year 7- $1,593 | Year 17- $2,854 | Year 27- $5,110 |
| Year 8- $1,689 | Year 18- $3,025 | Year 28- $5,417 |
| Year 9- $1,790 | Year 19- $3,207 | Year 29- $5,742 |
| Year 10- $1,897 | Year 20- $3,399 | Year 30- $6,087 |
The illustration above is intended to show the principle of compounding. This hypothetical chart is for illustrative purposes only and doesn't represent any specific type of investment. It doesn't include the impact of expenses or fees, which would have reduced the results of the illustration.
As you can see, compounding made a small difference in the ending balances during the early years. However, as more earnings were added, compounding made a significant difference over time. Remember, this is a simplified example.
Saving early is important
Time can be on your side. Saving for retirement early might make a dramatic difference in reaching your financial goals. In the example below you can see the difference an early start makes. Remember, this is a simplified example.
Hypothetical illustration
| Mary | Susan | |
|---|---|---|
| Started Investing At: | age 25 | age 45 |
| Yearly Contribution | $5,000 | $5,000 |
| Number of Years | 10 years | 20 years |
| Total Contributions | $50,000 | $100,000 |
| Rate of Return | 6% | 6% |
| Value of investment at age 65 | $425,304 | $206,661 |
This hypothetical example of compounding is for illustrative purposes only and does not represent any specific type of investment. It does not include the impact of expenses or fees, which would have reduced the results of the illustration.
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AP2023/05/0516