Compounding

Oh, the joys of compounding.

We often hear financial experts say that, if only workers in their 20s would save just $880 a month, they would have a million dollars by the time they retire at age 60, with a constant return of at least 5%. A 45-year-old would have to invest $3,741 a month to save the million dollars by age 60, almost four times as much. So, thanks to compounding, instead of buying that fancy new car or taking an expensive vacation, it pays to put money away for retirement. And keep it there.

In order for compounding to work, one has to reinvest the earnings on an asset. Rather than taking out the dividends you earn on a stock, or the interest earned in a savings account or CD, smart investors reinvest dividends to buy more shares, and the interest on a savings account becomes part of the ever-growing principal.

Richard invests $10,000 in an index fund called Grow Your Money Fast and holds it for 20 years. Since he reinvested all dividends, interest, and capital gains back into the fund, it is now worth $45,000. If he hadn’t reinvested the distributions, the value of his investment would only have been about $30,000. Since Richard held this fund in his retirement account, the savings will grow tax deferred as well.