“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”Albert Einstein
Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.
You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.
This is the power of compounding
Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.
When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.
In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.
However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.
It isn’t until these later stages that you truly start to see the benefits of compounding.
The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.
However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.