*This is part two in a series that will occupy the “money hacks” slot at Get Rich Slowly during April, which is National Financial Literacy Month.*

Albert Einstein reportedly called compound interest **the greatest mathematical discovery of all time**. On its surface, compounding is innocuous — even boring. “So what if my money earns 5.40% in a high-yield savings account?” you might ask. “What does it matter if it averages 10% annual growth in a mutual fund? Why is it so important that I start investing *now*.”

In the short-term, it *doesn’t* make a huge difference, but on the slow, sure path to wealth, we take the long view. Short-term results are not as important as what will happen over the course of twenty or thirty years.

In today’s episode of “Saving and Investing”, Michael Fischer examines the power of compounding. He uses several tables, but they don’t display well on YouTube, so I’ve taken the liberty of scanning them from his book. You’ll find them in the notes below the video. (This is by far the longest video in the series, but as Michael says, it may be the most important.)

**The power of compounding (10:29)**Here are the exhibits Michael uses. (*Warning:* these links open new windows.)

- exhibit A: $1000 compounding at 5% (years 1-10)
- exhibit B: $1000 compounding at 5% (years 11-20)
- exhibit C: $1000 compounding at 5% (ski-slope graph)
- exhibit D: Abby vs. Zak (the power of starting early) —
**this is important** - exhibit E: difference between 1% compounding and 3% compounding
- exhibit F: $600/month compounding at 7% for 30 years
- exhibit G: 16% interest doubles debt over five years

The following supplementary information may be of interest to you:

- Last spring I wrote about how compound returns favor the young. Vincent, a GRS reader, contributed a simple spreadsheet with which you can explore compounding.
- At one point Michael says: “By putting it in a CD or another instrument that is equally riskless…” High-return “riskless” investments include certificates of deposit (CDs) and money market accounts.
- “We tend to adjust our spending patterns according to what we make,” Michael says at one point. This is lifestyle inflation. Remember how you used to be able to survive on half of what you earn today? How was that possible? The problem is your lifestyle has expanded to match your income.

Finally, here is Michael’s explanation of why this subject — saving and investing — ought to be studied:

**Why this subject is so important! (1:13)**To summarize: **if you’re financially literate, you’re better able to make decisions about money**, whether on your own, or when working with a financial adviser.

*Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. Look for more episodes of Saving and Investing at Get Rich Slowly every weekday during the month of April. For more information, visit Michael’s site, Saving and Investing, or purchase his book. *

GRS is committed to helping our readers save and achieve their financial goals. Savings interest rates may be low, but that is all the more reason to shop for the best rate. Find the highest savings interest rates and CD rates from Synchrony Bank, Ally Bank, GE Capital Bank, and more.

This article is about Basics, Money Hacks, Savings

Dang, exhibit G sure is an eye-opener! I haven’t seen one of those graphs following credit charges in quite a while…I wish those were plastered in more places.

This guy seems like a straight shooter. I understand compounding, and I’m looking forward to the next entries. There are several subjects he’s going to cover that I likely don’t understand as well. Good stuff!

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Another great post J.D.

FT

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I really like this guy JD. In fact, Im prolly going to buy the book for my fiancee so she can start to understand what I have been talking to her about.

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Ben Stein just wrote a new article for Yahoo Finance that ties in beautifully w/ today’s post on Saving and Investing …

http://finance.yahoo.com/expert/article/yourlife/27943

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Compounding annual savings at 7% can be very misleading. If you average 7% per year but are not actually getting 7% EVERY year (some years higher, some years lower like with stocks and bonds), “when” a return occurs becomes more important than “what” your compounded average. Returns are relative to the amount of money at the time of the return (i.e. the same return on a larger balance yields more dollars).

If you are adding savings each year (and then eventually taking money out each year), the differences can be huge, and it is very possible to have a lower average return result in more money than a higher average based on WHEN returns happen for each. Typically, the higher the average return, the wider the range of possible one year returns (risk vs. reward).

For the long-term investor, this is market volatility risk and is much more than just a “paper loss.” It can mean the difference between spending your golden years relaxing or greeting shoppers at Wal-Mart.

If you don’t believe it, try it on an Excel spreadsheet. Throw down a wide range of returns that average 7%, 8%, 9%, or 10% for 10 years For example: for a 10% average return, most of the years should be between -10% and +30% with 2 or 3 years being outside that range (you can also use historical index numbers). Then add $1,000 each year, and calculate your ending balance. Compare it to using the average return number for all years. Now change the order of returns and note the differences. Try it several times, put a bull market at the beginning, then do it with one at the end. You’ll get a different answer each time, all with the same average return. Now imagine the effect over 20, 30, or 40 years or with larger contributions. Try it with withdrawals too.

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Just wanted to say that I’m enjoying your series. Just wanted to comment on Dylan’s rather dreary (but valid) comment and ask if anyone could give me the short answer on what impact (if any) dollar cost averaging has on market volatility risk. I haven’t yet crunched the numbers myself.

Also, I didn’t realize it was financial literacy month, but I just started a series on investing for young adults in their twenties over on my blog (shameless plug, I know). Please check it out and leave me any comments or suggestions you may have. Thanks!

http://www.ryanwaggoner.com/2007/04/02/investing-for-young-adults-part-1-financial-goals/

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Great post! Keep up the good work.

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@ Ryan Waggoner – I hope it was the concept and not my delivery that you found dreary. Either way, you can learn more about the myth of dollar cost averaging at, http://www.fpanet.org/journal/articles/2006_Issues/jfp1006-art8.cfm. To clarify, dollar cost averaging as a deliberate strategy (bad) is when you invest part of your cash-on-hand over a period of time (i.e. You have $5,000 and invest $1,000 at a time over then next 5 months). This is different from doing it because you are investing as you earn it on a monthly basis (good).

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[...] Rich Slowly personal finance that makes cents « Saving and Investing: The Power of Compounding | [...]

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I simply read the article, and didn’t watch the clip (I’m at work), BUT:

In exhibit D, both appear to be contributing 2000 per year. Zak starts ten years later, and finish with 500 bucks less. Is this supposed to motivate to start earlier, or demotivate?

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@CoryIn that exhibit, Abby contributes $2000 a year for ten years. Zak contributes $2000 a year for TWENTY years. Abby contributes $20,000 total. Zak contributes $40,000 total. Abby contributes half as much as Zak, but because of compounding, she ends up with the same amount.

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[...] Excellent overview and videos of the Power of Compounding (here) [...]

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I must be missing something: in exhibit F, why does the “contribution” keep going up? Interest has its own column, so is the idea to increase the contribution every year ($630 per month in year 2 etc)? Or am I just being simple?

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> in exhibit F, why does the “contribution” keep going up?

Good question, and I too am wondering whether this is an error or deliberate. If deliberate, then I also don’t get it.

(I haven’t watched the videos.)

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