The Power of Compounding
Simply put, compounding is earning a rate of return on your investments, assuming you reinvest all earnings. Suppose, for instance, you invested $200 and reinvested the full amount of your earnings each year. Also, suppose your investment returns 10% annually. Watch what happens to your earnings:
| Year 1 | Original $200 investment earns $20.
|
| Year 2 | Original $200 investment earns $20, $20 earnings from Year 1 earns $2.
|
| Year 3 | Original $200 investment earns $20, $20 earnings from Year 1 earns $2, $2 earnings from Year 2 earns $0.20. |
Thanks to the power of compounding, your original $200 investment earns you $22.20 over 3 years.
The Early Starter versus The Late Bloomer
The most important lessons to learn about compounding are to start early and reinvest your earnings. The earlier you start, the greater your earnings over time. Compare the results of two investors in the table below: the Early Starter invests only half as much as the Late Bloomer, but by starting sooner, the early starter earns significantly more.
| Early Starter | Late Bloomer | ||
| Age | Contribution | Age | Contribution |
| 25 | $2,000 | 25 | None |
| 26 | $2,000 | 26 | None |
| 27 | $2,000 | 27 | None |
| 28 | $2,000 | 28 | None |
| 29 | $2,000 | 29 | None |
| 30 | $2,000 | 30 | None |
| 31 | $2,000 | 31 | None |
| 32 | $2,000 | 32 | None |
| 33 | $2,000 | 33 | None |
| 34 | $2,000 | 34 | None |
| 35 | No more contribution | 35 | $2,000 |
| 36 | 36 | $2,000 | |
| 37 | 37 | $2,000 | |
| 38 | 38 | $2,000 | |
| 39 | 39 | $2,000 | |
| 40 | 40 | $2,000 | |
| 41 | 41 | $2,000 | |
| 42 | 42 | $2,000 | |
| 43 | 43 | $2,000 | |
| 44 | 44 | $2,000 | |
| 45 | 45 | $2,000 | |
| 46 | 46 | $2,000 | |
| 47 | 47 | $2,000 | |
| 48 | 48 | $2,000 | |
| 49 | 49 | $2,000 | |
| 50 | 50 | $2,000 | |
| 51 | 51 | $2,000 | |
| 52 | 52 | $2,000 | |
| 53 | 53 | $2,000 | |
| 54 | 54 | $2,000 | |
| Total Contribution | $20,000 | Total Contribution | $40,000 |
| Total Earnings at 8% | $135,042 | Total Earnings at 8% | $91,524 |