You may have been told by an older relative or a social media influencer that compounding is how you become wealthy.

Compounding is one of the most powerful forces in finance. It can cause wealth to grow at what can feel like a very fast pace. Once the compounding ball is rolling, it could take on a life of its own.

But what is it exactly and how does it work? And how do you make it work for you?

In this month’s Wealth Management 101, we’re talking compounding.

Want to be Wealthy? Plan on it!

$0.01 vs. $1,000,000

Compounding is often taught using the doubling penny illustration.

Say that I offer you the choice between one penny that doubles every day for 30 days or $1,000,000 today? Which would you choose?

You might be inclined to take the $1,000,000. How much could one penny add up to in just one month?

The math says that at the end of 30 days, if you took the penny that doubles daily, you’d have $5,368,709.12. That’s how powerful compounding can be.

Look at the graph below.

Notice that nothing much seems to happen for the first 25 days or so. Then suddenly, compounding just takes off.

How would you apply this to real life?

Application

The principle behind compounding is that you allow your money to earn money. You then take that new money and allow it to earn money. This behavior is often called reinvesting.

Reinvesting

Your money can earn money in two primary ways. You can earn interest income, or dividend income.

If you own bonds, or an interest-bearing account at a bank, you likely earn interest. You can take that interest income as cash to spend or you can use that interest income to buy more bonds or add to your cash deposits. When you use your income to buy more of the thing that makes money, you are reinvesting and compounding.

If you own stock shares, those shares might pay a dividend. As a shareholder, you have the option of taking that dividend in cash so you can spend it or of using it to buy more stock. This is another form of reinvesting and compounding.

The Three Ss of Stocks

In Practice

Compounding sounds great in theory, and it is!

But it takes a very long time to see results which can be frustrating for investors just starting out.

Let’s look at another illustration.

Say that I fund an IRA with $7,000^{[1]and invest the account in a stock index fund which has historically returned 10% on average each year. Let’s also say that I do not add to the account or take money out of the account for 40 years.}

Do I Need an IRA?

After five years I could have up to $11,274. When does this get exciting?

After 10 years I could have as much as $18,156. Ok…when does the money start rolling in?

After 20 years I could have as much as $47,093. Now we’re getting somewhere!

After 30 years I could have as much as $122,146 and now I’m starting to feel pretty good about my little $7,000 IRA.

Over time, your $7,000 could grow to as much as $316,815. That equates to growth of 4,426%. By letting it compound.

And there’s the rub!

Leaving money alone for 40 years is hard.

It takes patience, discipline, and the ability to ignore scarry sounding headlines when the economy struggles or the market tumbles.

Compounding is a powerful force. But one that works best when left alone.

Having a Financial Advisor at your side can help you stay invested and keep compounding going. I’m here to help keep you on track, even when the world looks scary.

Want to learn more about how compounding can work for you?

Schedule your free one-hour consultation!

All investments carry some level of risk, including loss of principal. Examples provided are hypothetical and for illustrative purposes only and not intended to be reflective of results you can expect to achieve.