In our previous blog posts, we explored key topics essential for securing a better financial future through investment. We discussed the fundamentals of investing, the advantages of passive investing, and the growing popularity of passive investing in recent years. We also covered strategies for managing sudden market downturns and considerations for long-term investors during current market highs.
What?
Compounding is the process where the returns on an investment are reinvested to generate additional earnings over time. Essentially, it’s earning interest on your interest, which leads to exponential growth of your investment. This creates a snowball effect, where your investment grows larger and larger over time. The longer you leave your money invested, the more pronounced the compounding effect becomes. This makes time a critical factor in maximizing the benefits of compounding.
So What?
I am going to share illustrative examples of the impact of compounding over time. In our previous blog post, we explored the most popular ETFs/funds, S&P 500. The oldest S&P 500 ETF, SPY, has more than 31 years of history since its launch on 01/22/1993. Since its inception, SPY has accomplished 10.1% of annualized return. So, it is reasonable to assume 10% average annual return for this hypothetical investment scenario. Let's assume that you start investing at the age of 20 with $5 per day. In 10 years, you reach $31,352. Note that your return (the green bar, $13,102 at year 10), is smaller than your investment (sum of the $5/day for 10 years, the blue bar in 2034) of $18,250 (see below).
Let's re-run this scenario for 20 years. Here is the result.
In 20 years, you reach $116,563. Note that your return in 20 years (the green bar, $80,063 at year 20), is now much larger than your investment (sum of the $5/day for 20 years, the blue bar in 2044) of $36,500. You can see the snow ball effect emerging.
Let's re-do this scenario for 30 years. Here is the result and it is even more exciting.
In 30 years, you reach $348,160. Note that your return in 30 years (the green bar, $293,410 at year 30), is now more than 5 times larger than your investment (sum of the $5/day for 30 years, the blue bar in 2054) of $54,750. You can clearly see the snow ball effect is taking over.
Let's re-do this scenario for 40 years. Here is the result you expect at the age of 60.
In 40 years, you reach $977,621. Note that your return in 40 years (the green bar, $904,621 at year 40), is now more than 12 times larger than your investment (sum of the $5/day for 40 years, the blue bar in 2064) of $73,000. Now you become a near millionaire with investing just $5 per day.
Let's assume you continue to invest $5/per day until you reach 70. With 50 years of consistent investing with $5 per day the result is simply amazing!
In 50 years, you reach $2,688,436. Note that your return in 50 years (the green bar, $2,597,186 at year 50), is now more than 28 times larger than your investment (sum of the $5/day for 50 years, the blue bar in 2074) of $91,250. Now compare the height of the green bars (your investment returns) compared to that of the blue bars (sum of all your $5 investments). You can barely see the blue bars!
Now you become a multi-millionaire with investing just $5 per day. You don't need to be a financial expert to become a millionaire. You don't need a large sum of money to start with. You don't have to sweat and fear at the market downturns. You just need to be consistent with a good passive investment vehicle, like S&P 500 ETFs/funds. This is the power of compounding over time! This is the easiest way to become a millionaire - slowly but surely!
Now What?
Start Early: The earlier you begin investing, the more time your money has to grow. Even small, consistent investments can grow substantially over time.
Stay the Course: Avoid the temptation to withdraw or move your investments in response to market fluctuations. Compounding requires patience and discipline.
Invest Regularly: Set up automatic investments, a common feature available at all major brokerages, to ensure you are consistently adding to your investment principal.
Reinvest Earnings: Whenever possible, reinvest any dividends or capital gains. This increases the principal amount, leading to potentially higher returns in the future.
Minimize Fees and Taxes: High fees and taxes can significantly eat into your returns. Choose passive investment options with lower fees and consider tax-efficient investment vehicles, such as ETFs.
Concluding Remarks
The power of compounding is a key driver of wealth accumulation in long-term investing. By starting early, investing regularly, reinvesting earnings, and maintaining a disciplined approach, you can significantly enhance your financial future. Time is your greatest ally in this journey, so the sooner you start, the better. Stick to the plan regardless of market conditions.
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