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The Power of Compounding

Albert Einstein is widely rumored to have called compound growth the most powerful force in the universe. Compounding is the process by which an asset generates earnings not only on the initial principal but also on the accumulated earnings from prior periods. In simple terms, it means generating earnings on previous earnings.

The future value of any investment depends on three main things:

  1. the dollar amount(s) you contribute;
  2. the rate of return you earn;
  3. the length of time you save.

Naturally, increasing any of these elements can increase the future value of your investment, but one component is more important than the others: time. The longer your money is invested, the more compounding can potentially grow your assets.

Years ago, Warren Buffett wrote that the Native Americans who received $24 from the sale of Manhattan Island in 1626 may have gotten the better deal. He explained that if the $24 had been invested at only 6% interest, it would have grown today to a higher value than the multi-billion-dollar current real estate value of Manhattan.

The table below shows the dramatic effect of compounding on a $10,000 investment, even at relatively modest rates:

  5% 10% 15% 20%
5 Year $12,763 $16,105 $20,114 $24,883
10 Year $16,289 $25,937 $40,456 $61,917
15 Year $20,789 $41,772 $81,371 $154,070
20 Year $26,533 $67,275 $163,665 $383,376
25 Year $33,864 $108,347 $329,190 $953,962
30 Year $43,21 $174,494 $662,118 $2,373,763

While compounding is powerful and can help increase your wealth over time, the key to its success is to start saving early, avoiding major losses along the way. Of course, you can’t go back in time to begin saving 10 years ago. What you can do is not wait another 10 years to start. Save for your future right now, and let compounding work its magic for you.

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