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Compounding Returns: Why Investing Early and Consistently Can Make All The Difference

 

Investing in the modern era can seem like a daunting task in the era of technology in which we are living. Investors (especially young investors) are oftentimes inundated with adverts, news articles, and social media posts trying to convince them that the means to strike it rich is right around the corner. They play on the emotions by trying to convince you that you could miss out on the next big thing by not putting your money into this hot new investment, oftentimes called FOMO or Fear of Missing Out. We have seen this behavior lead to wild fluctuations in market values for some companies. One recent example is the mania surrounding the rapid fluctuation of GameStop's share price resulting from a coordinated effort in online communities to drive this stock price up.

 

While these kinds of events are surely interesting to observe, the reality is that the overwhelming majority of people who engage in this kind of speculative behavior will not become wealthy from this type of trading. The data shows us that the majority of active stock-pickers do not outperform relative to the indexes of a particular asset class. To put it bluntly: With few exceptions, wealthy people do not become wealthy because they received a good stock tip at the water cooler from a colleague. The way that successful investors accumulate wealth isn't flashy, but it is effective: The power of compounding returns.

 

Compound returns occur when interest and dividends that are accrued on your principal investment start to accrue interest and dividends themselves. As a simplified example, if you invest $1,000 into a fund that earns 5% annually, after the first year, you would have $1,050 (your principal investment of $1,000, plus $50 in accrued return). After the second year however, your new starting balance of $1,050 would have grown to $1,102.50, and increase of $52.50 from the previous period despite no additional deposit. This is because as times goes on, you earn a return on your total investment, including any appreciation in stock price, earned interest, or dividends, not just your initial contribution. Let's expand upon this using the SEC's Compound Interest Calculator and see how your money would grow if you started saving various amounts monthly, starting at different ages to further illustrate the power of compounding over time:

 

Retirement Account Balance at 65, assuming monthly deposits and 5% interest rate:

 

Starting at Age 25

Starting at Age 35

Starting at Age 45

Starting at Age 55

Saving $100/month

$144,959.73

$79,726.62

$39,679.14

$15,093.47

Saving $250/month

$362,399.32

$199,316.54

$99,197.86

$37,733.68

Saving $500/month

$724,798.65

$398,633.09

$198,395.72

$75,467.36

Saving $1,000/month

$1,449,597.29

$797,266.17

$396,791.45

$150,934.71

SOURCE:  U.S. SECURITIES AND EXCHANGE COMMISSION COMPOUND INTEREST CALCULATOR

As you can see above, compounding returns over time can be a serious force-multiplier for your portfolio, with the power to drastically increase the total nest-egg that is accumulated over the years. This leads to a snowball effect that over time can help your investment grow exponentially. Below is an expanded chart showing how even $100 invested per month, contributed consistently over the course of 40 years would look, assuming a relatively conservative fixed rate of return of 5% for this calculation:

 

Once again, we see that the power of compounding returns takes your principal contributions of $48,000 over a period of about forty years, to an ending value of $144,959.73, over three times your actual contribution amount. If we assume dividends are received and reinvested, the growth of your portfolio would be even higher. This is a great example of the power that compounding interest has on the return of a portfolio, and how the earlier you start, the greater the compounding effect is. The higher the principal amount being compounded, the greater the ending value. This is all the more reason to start investing as early as you can, and contributing as much as is feasible without cutting into your needed living expenses.

If you are an investor looking for the best way to maximize your retirement, the best thing that you can do so is ensure you are maximizing your contributions to any employer-sponsored investment vehicles and receiving any matching contributions available to you. For some investors, especially those in the early-career stage, contributing the maximum allowable contribution may not be feasible, in which case a target of 10-15% of income contributed to retirement accounts may be more appropriate. One technique that investors may find helpful to assist in saving more over the long-term is to automatically increase your savings rate proportionately to any increase in salary or bonus that you receive. For example, if your salary increases by 4%, a good practice is to allocate at least half of this increase in pay to savings/investment accounts. Oftentimes, setting aside funds in this manner before it hits your paycheck makes it easier to keep your savings rate increasing along with your lifestyle spending increases. Additionally, many people find that itemizing their expenses over a one or three month period using bank/credit card statements allows them to analyze where they can save money in their budget which can then be redeployed into your investment accounts such as a 401(k) or an IRA. There are a variety of ways to increase your savings rate, some more difficult than others, but doing so will help to set you up for success in retirement.

As Warren Buffet once opined: "The stock market is a device for transferring money from the impatient to the patient." Do not be swayed by talking heads and financial pundits telling you that the sky is falling, or that this particular investment is different than all of the rest, many of these individuals have a vested interest in convincing you to do what they want, which may or may not align with your own goals. Time in the markets (not timing the markets), and consistent contributions are key when it comes to successful investing. Consult with a financial advisor about building a financial plan to identify the appropriate time horizon and portfolio allocation for someone in your shoes.

 

 

About the Author:

Justin Seidenwand is an Associate Financial Advisor at Fullen Financial Group. He is a 2019 graduate of The Ohio State University, earning a Bachelor of Science in Consumer and Family Financial Services with a focus in Family Finance. Justin has years of experience in client-facing roles with an emphasis in relationship management, and he strives to help Fullen Financial Group build long-term relationships with clients and their families. While working to complete his education at The Ohio State University, Justin spent several years working in the telecommunications industry, and was also a formally-trained chef, attending vocational school for culinary arts while still in high school. In addition to his academic and professional achievements, Justin is also a six-year veteran of the Ohio Army National Guard, serving as a Military Police Sergeant in a team-leader capacity. Justin lives in Columbus, Ohio.

Contact Justin: This email address is being protected from spambots. You need JavaScript enabled to view it. 

Disclaimer: 

All expressions of opinion reflect the judgment of the authors on the date of the post and are subject to change. All investments and investment strategies have the potential for profit or loss. · Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized financial advice. Legal and tax advice is general in nature. You should always consult an attorney or tax professional regarding your specific legal or tax situation. Fullen Financial Group is not engaged in the practice of law. · Hyperlinks on our posts are provided as a convenience. We cannot be held responsible for information, services or products found on websites linked to ours.