The Power of Compounding

Compounding, which is earning interest on interest, is best described by an ancient story:

In the sixth century a Maharaja ruled over the Indus Valley in northern India. Bored, he asked his court gamesman to develop a new game for him.The gamesman created chaturanga, the army game, and the precursor of chess, played on a board of sixty-four squares.The Maharaja was delighted and asked the gamesman what he would like as a reward.

"Nothing much," answered the gamesman, "Just one single grain of wheat on the first square, two grains on the second, four on the third, eight on the fourth, and so on across the board." In calculating the gamesman's reward, the Maharaja discovered that, even before he was halfway across the board, he owed the gamesman more grains of wheat than existed in all of India. He solved his problem by ordering the gamesman executed.

The gamesman was earning interest at the rate of 100 percent per square, far more than what we could ever expect to earn. However, the principle of compounding interest remains the same. Earning interest on interest can add up impressively over the long term.

Example
Suppose you have a mutual fund that performs at the rate of 8 percent per year. If you invest $1000 annually, and leave all your money in the fund, in twenty-five years you will have $73,110. If you invest $10,000 annually, in twenty-five years you will have $731,100.

Investing for the long term and reinvesting the earnings pays off.The annual performance makes a great deal of difference too. If our mutual fund earned10 percent rather than 8 percent, our twenty-five year nest egg would swell to $983,500.This represents a gain of $252,400 with the same annual investment, but a 2 percent higher rate of return.The two most important factors in compounding, therefore, are time and rate of return.

General Rules
The power of compounding leads to some general rules in investing:

• Do not let funds accumulate without earning interest.The money under your mattress, or in a noninterest-bearing bank account, is earning 0 percent per year. When you factor in inflation, you are losing money every year at the rate of inflation.
• Whatever your investment, make regular deposits. If you skip a single $100 per year investment at 12 percent, after twenty-five years you will have lost $13,333.
• Look for investments that pay the highest rate of return without undue risk. Small differences in return add up over the years.
• Arrange for at least four month's salary to be cashable at any time in case of emergencies such as job loss. Even a 15 percent return on your investment over twenty-five years may not be worthwhile if you have to pay a huge penalty for cashing in early.
• Every dollar you owe in credit card balances, personal and car loans, and mortgages is a dollar not invested. Pay off your after-tax loans as soon as possible to free your money up to work for you, not your creditors.
• Ask your investment advisor how best to make the power of compounding work for you, based on your financial situation and the amount you have to invest. Since there are many alternatives with differing risks and rates of return, an advisor can help you make the best choice. If you follow these general rules, you can create a sizable nest egg for yourself and not have to worry about being executed for this accumulation.