The power of compounding: How your wealth snowball grows with time

The power of compounding: How your wealth snowball grows with time

So much of financial success involves good habits practiced over long periods of time.

Yes, you can still have a positive impact on your financial future if you're starting late in life — but if you're 59 years old and just beginning to think about financial freedom, you have a lot of work to do.

But if you're 19, you have an extra forty years to set yourself up for financial success. This extra time makes a ginormous difference!

A lot of this is due to the magic of compounding. Over the short term, your investment returns don't help a whole bunch. But over the long term? Over decades? Wow! Compounding can help you create a truly impressive wealth snowball.

I once received email from a reader named Anders who testified the power of compounding:

I used to save money in funds without knowing more than it gave a better interest than ordinary savings accounts. Then a few years ago I came across a book that explained compound interest and showed graphs of how it works. I was blown away by the idea!

I think, for me, that was the biggest impact on my way of thinking about savings and it got me more interested in the stock market too. So in my opinion, the things people who don't know too much about savings/investing need to hear is about how compound interest works and how the stock market works.

We'll leave “how the stock market works” for another day. (If you want to know more right now, check out my articles on stock market returns and how to invest.) Today I want to look at why some folks consider compounding to be the most powerful force in the universe.

The Power of Compounding

On its surface, compounding is innocuous — even boring. How much does it matter if you start saving now? Will it really affect what you can spend in the future?

To illustrate the power of compounding, I spent far too much time playing with spreadsheets. (Seriously. Kim managed to get like three major projects done in the time it took me to generate the following numbers and graphs. But I had more fun.)

Note: All of the numbers that follow are based on certain assumptions. For each of the three asset classes — stocks, bonds, gold — I'm using the long-term average real return: 6.8% for stocks, 2.4% for bonds, and 1.2% for gold. That's what these investments return over decades (not year to year) after accounting for inflation. However, it's very important to undertand that average is not normal. Returns can (and do) vary widely from year to year.

First up, here's a basic look at compounding in action. This table assumes you invested one dollar into each of stocks, bonds, and gold. Based on historical averages, I've calculated how much your dollar would have grown to at the end of each year for fifty years:

Compounding $1 Table

As you can see, compounding doesn't really do much during the first few years. After a decade, your $1.00 would nearly double if invested in stocks. (Remember, this is inflation-adjusted. The nominal number would be greater. But this is what your dollar would be worth.) If invested in bonds, that $1.00 would grow to $1.27. And if you invested in gold? That $1.00 would grow to $1.13. (For the record, my research shows that real estate offers long-term returns similar to gold. Others say real estate returns are worse than gold.)

The longer your money remains invested, however, the more powerful compounding becomes. After ten years, your $1.00 in stocks grew to nearly $2.00. Afters sixteen years, it will grow to nearly $3.00. In 20 years, it'll grow to nearly $4.00. In 24 years, it'll be worth more than $5.00. From there, the growth becomes even more rapid. By year 40 — which, yes, is a very long time — you're earning more than a dollar every year.

Compounding a One-Time Investment

That's a fine hypothetical example, but nobody invests just a dollar. Let's assume instead that you made a one-time $5500 investment in your Roth IRA. How would your future returns on that investment vary depending on where you put the money? Here's a table that demonstrates:

Compounding a One-Time Contribution (Table)

As you can see, compounding can make a huge difference — especially when time is allowed to magnify the difference in annual returns. (This is one reason index funds outshine managed mutual funds. Index funds, as a whole, earn that 6.8% average annual return that the overall stock market earns. Managed funds earn that less fees, which average about 2%. That's not much in the short-term, but it's a huge amount in the long-term.)

For the visual thinkers out there, I've created a series of charts that dramatically demonstrate the difference that compounding can make over time.

Compounding a One-Time Contribution (10 Years)

Compounding a One-Time Contribution (25 Years)

Compounding a One-Time Contribution (50 Years)

Over fifty years, compounding can make a dramatic difference if you're able to earn higher returns on your investments! (Who has a fifty-year investment horizon? Well, your typical college student does, for one.)

The Importance of Saving

Now, it's often said — sometimes even by me — that your investment returns are less important than your investment contributions. That is, how much you invest matters more than where you invest it. Here, for instance, is an XKCD comic belittling the power of compounding:

XKCD on compounding

How true is that? Let's look at another hypothetical example.

In this case, assume you invest $5500 on January 1st for the next fifty years. How would your investments grow in this case? Here's the table:

Compounding Ongoing Contributions (Table)

And here are the charts:

Compounding Ongoing Contributions (10 Years)

Compounding Ongoing Contributions (25 Years)

Compounding Ongoing Contributions (50 Years)

Look at that! Investing more does make a difference. Shocking! Sarcasm aside, there are a couple of things to note about these numbers:

  • First, investing more absolutely produces better results. The more you contribute, the more there is to compound. If you want to build a wealth snowball — and I hope you do — the best thing you can do is invest as much money as possible.
  • Second, when you invest more, you erase some (but nowhere near all) of the difference between the rates of return. Take a look at our one-time investment example. In that situation, stocks double gold by year 13 and they double bonds by year 16. But with ongoing investments, it takes stocks 21 years to double gold and 26 years to double bonds.

Yes, the amount of you save is more important than the returns you earn. That said, there's no denying the extraordinary power of compounding over time. Real-world numbers bear this out.

A Real-Life Example

Finally, let's look at a real-life example or two. These are actual numbers from actual accounts.

To start, here's the balance history for the 401(k) I started back when Get Rich Slowly was throwing off huge wads of cash:

Real-World Compounding on My 401k

The blue line represents my actual balance over time; the orange line represents my balance if I had not been invested. (In other words, if I were earning no return because I stuffed my money under a figurative or literal mattress.)

I've contributed a total of $60,518 to this 401(k) since the end of 2008. In that time, it's grown $117.121.19 so that my balance today is $225,331.75. That's 193.5% growth in just over eight years (or 12.31% annually).

Here's a second example, this time with the moved money from my box factory retirement plan to a rollover IRA:

Real-World Compounding on My IRA

Here, I've contributed a total of $65,027.41 to the account — most of it in 2009, but a few thousand just last month. (I closed a smaller IRA and moved the proceeds to this account.) In that time, I've gained $86,425.88. That's 132.9% growth (9.73% annually) in under eight years — all because of compounding.

The Bottom Line

Based on all of this, there are three keys to make compounding work for you:

  • Start early. The sooner you start, the more time compounding has to work in your favor, and the wealthier you can become. The next best thing to starting early is starting now. Yes, if you start investing at age 19, you'll enjoy better results by the time you're 65. But even if you're 59, compounding is your friend and you shouldn't hesitate to invest.
  • Stay disciplined. Make regular contributions to your savings and retirement accounts, and do what you can to increase your deposits as time goes on. Your goal should be to generate as large a saving rate as possible, to widen the gap between what you earn and what you spend. Don't be tempted to cash out a retirement account when you switch jobs. I see so many people make this mistake, and it makes me want to cry. Don't be tempted to sacrifice your future security for a few bucks today.
  • Be patient. Don't touch your investments. Compounding only works if you let your money grow. Remember: You're creating a wealth snowball. At first, your returns may seem small, but they'll become enormous as more money accumulates.

Do these things, and your wealth snowball will grow. Sure, there might be some years where your investment balance decreases rather than increases. Again, that's normal. The examples I've used here assume stocks, bonds, and gold return a stead annual average. They don't. Their returns fluctuate — sometimes wildly. But, over long periods of time, your investment accounts should steadily swell.

For a brilliant example of compounding in real life, turn to American statesman Benjamin Franklin. When he died in 1790, Franklin left the equivalent of $4400 to each of two cities, Boston and Philadelphia. But his gift came with strings attached. The money had to be loaned out to young married couples at five percent interest. What’s more, the cities couldn’t access the funds until 1890 — and they couldn’t have full access until 1990. Two hundred years later, Franklin’s $8800 bequest had grown to more than $6.5 million between the two cities! True story.

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John
John

I like the real world examples… One other requirement is to ‘stay the course’ in bad times. My accounts (mostly index funds) dropped by near 50% during the housing crash. Your real-world charts would not have looked good for me for the date range from 2000 – 2008 (post-crash). I would have been better off putting the $$ under my mattress. However, I stayed the course, continuing contributions and holding on to my devalued investments. Now, all is good and I’m near the average rate of return over my entire investment time horizon. A long term view is needed for… Read more »

Jon
Jon

John,

You make a great point. Some of us younger folks have only been investing in this lengthy bull market and have not been through a recession yet. I’m setting aside money for the fire sale during the next downturn, but I think a lot of people will panic just like last time and pull out at the wrong time.

Marina
Marina

Yeah, but because a lot of people panic and sell when prices are low instead of buying, those who do buy get a really great deal!
I was too broke in 2008 to be able to invest much, but what I was able to spend at the fire sale has by now made me much less broke. If I can maneuver through a couple more fire sales at the stock market I’ll be able to retire!

Sequentialkady
Sequentialkady

I started an IRA in 2000, the year I got my first “real” job. I’ve been through the tough times of 2001-2003, and the hot mess of 2007-2011. There were times in 2001-2003 that my account was worth less than what I had invested into it, and yes, that’s really REALLY discouraging.

I took the view that the low market meant that stocks were “on sale” and that I was getting a discount now that would pay back later.

I have invested $83,000 into my IRA.
It is currently worth over $175K

‘Nuff Said.

S.G.
S.G.

A story of compounding without the rule of 72?

The MathChick cries.

Smile If You Dare
Smile If You Dare

Great examples.

Another point:

If one INCREASES one’s investments over time, then the increase in results is astoundingly better!

PFgeek
PFgeek

Oh yes! Compounding is an investor’s best friend :)) It’s so exciting to draw up charts depicting how much our money will grow over the years. I spent 3 hours today on my spreadsheet program doing this, and the results are making me so happy! If all goes to plan, I am going to be financially independent in 6 years from now!! The magic of compounding 😀

Jon
Jon

These are great numbers and gives me further confidence in my 100% stock allocation instead of the 70/30, at least until I’m 35-40. There is so much growth that would be missed otherwise.

Mark
Mark

Jon,
Keep going. I’m 56 and still in about 90% and have never regretted it.

Laura
Laura

Wish I’d gotten Mark’s advice 20 years ago…

Joe
Joe

Compounding is awesome. Your investment is doing very well. Nice job not messing with it too much.
I’m going to hire our kid as a photographer and child model this year. We’ll put everything in a Roth IRA and it will have 60 years to compound. That kind of timeline looks amazing. If he can keep it up, he’ll be set for early retirement.

Leah
Leah

My mom took me to the bank to get an account with my very first paycheck at age 15. I learned about banking and CDs from her and the banker. How I wish, so fervently, that the banker had thought to mention a Roth IRA to me. I didn’t need the money, and I definitely could have put in at least a little something each year. I cry now thinking about all those lost gains. At least I started my Roth IRA pre-2008 and got some gains from getting in low those years.

WantNotToWantNot
WantNotToWantNot

Compounding. Love it, love it. I like the SEC’s website best at: https://www.investor.gov/additional-resources/free-financial-planning-tools/compound-interest-calculator At that calculator, you can plug in your own numbers: your initial investment, your anticipated additions in future, the years you will hold the investment, and the anticipated range of interest earned. Voila, you get a dandy graph showing you how much the magic of compounding will pay off in the years to come. If you are new to all this, it’s a great site for inspiring more, more, more saving, and also for staying the course should a downturn in the markets come. Just keep planting… Read more »

DDC
DDC

The great Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” I started maxing out my 401k when I was age 30. I lived below my means, drove a used car, made most of my own meals and lived frugally except for a few select experiences (vacations and experiences, not things). I watched my portfolio drop by 40% during the bear market (I had an aggressive portfolio) but rode it out. At age 57, I work part-time and my net worth is over… Read more »

freebird
freebird

When you save (and spend) matters as much as how much you set aside. That 50-year compound growth curve on a stock investment returning 7% should be alarming to any youngster who is contemplating taking out student loans. Sure your lender will happy to front you a semester or two abroad, but I wonder what your future self would have to say about this decision? It may not be fashionable but there can be a lot of benefit to saving on rent by moving back home after graduating college and starting a job. Sure you earn enough you can afford… Read more »

Mike
Mike

What is a good index fund stocks/bonds allocation for a
54 years old investor.

common man
common man

An appropriate allocation for a 54 yr old investor depends on many variables beyond age. Existing debt, savings, income, planned years to retirement, etc…all work to establish an allocation appropriate for any given individual. What you expect to realize on future returns also comes into play. A good reference is The Little Book of Common Sense Investing, by John Bogle, founder of Vanguard. In the most recent edition of this book, Bogle gives an outlook over the next ten years of 4% annual return on equities and 3.1% on bonds. The 4% figure results from 4% earnings, 2% dividends and… Read more »

The Poor Swiss
The Poor Swiss

Really good examples. Even though I’ve seen this kind of graph many times, it’s still impressive to see the power of compounding in effect. The Franklin example is really good as well, never heard of it before!

Thanks

Ben
Ben

Not too sure about this 50-year timeline. Most college graduates have student loans to pay, so they need to make the choice between paying off the loans or investing into funds. Paying off the loans is almost always better as the interest rate on the loans are going to be higher than the return rate on investments.

Dave
Dave

One of my teachers put it to me this way, when talking about saving sooner rather than later.
You aren’t losing your first year of investment (say $1000), you’re losing the last year of compound interest. That final year of returns before you cash in, whether its the 20th or 60th year, is what you’re losing out on.
The 20 thousand odd dollars of your last 8 year example is what you’re losing out on. That’s a huge motivator to save earlier.

William
William

The real problem is having the ability to save enough to make anything useful. Even your own example shows only a 2.25:1 ratio between saving, and compounding the savings. You need real money saved up. This is something that only the “upper middle class” or the “immigrant mindset” can do. Everyone else is always living paycheck to paycheck. $30/week for smokes is way more satisfying–you get something out of it–than putting that in savings. Now the other problem is setbacks. When you put money in a 401K or an IRA, you have to pay a 10% penalty on early withdrawal.… Read more »

Fran Smith
Fran Smith

Of course, this is all based on trust in our financial institutions. We had that for many years due to U.S. government backing, insurance – and yes, regulation to keep the bad wolves at bay. We should not tolerate the weakening of those safeguards so that a small segment of society makes a bundle at everyone else’s expense.

Steven
Steven

interest rates use to be higher making it worth more my dad made most of his monies off of cds and interest rates but sense fed lowered the interest rates from 8 and 6% to lower his income got cut almost in half, which hurt a lot of older people and younger people.

Lena
Lena

How does real estate investment performance compare? Would love to see the data comparison presented similarly.

steven
steven

well student loans and education loans are and can be kept separated from other aspects just like VA loans are. VA get special loans are lower interest rates which are not tied into general market same could happen for student loans. In general there is a lot of reason to raise interest rates one of them being fact that it significantly improves peoples lives special alder people and people who retired. interest rates should keep up with inflation honestly so people have that extra income and have less change of losing there homes. https://www.cnbc.com/2016/11/17/200-years-of-us-interest-rates-on-one-chart.html alot of people made majority of… Read more »

Randall Parker
Randall Parker

Compounding Interest works over time EXCEPT when you factor in Wall Street Bankruptcy rules. There is nothing to compound when it is bankrupt and the CEO/CFO walks away with a $10m+ severance parachute. Money managers have little incentive to perform outside of collecting their back end and the up front fees, then they divy up the carcass when they fail. IRA/401K holders pay that bill

MikeF
MikeF

Silly question…. I don’t really understand where the money comes from to reinvest… Is this dividends or are you cashing in your yield yearly to reinvest?

Dave
Dave

Looks great on paper but realistically, the returns are not as high.. good nevertheless and better than being in the negative

RichestManInLondon (@RichestManInLDN)
RichestManInLondon (@RichestManInLDN)

There will never be a day when I won’t be excited to read another article on compounding!

The one topic that never gets out! well done on plugging in all those examples. This is so useful.

Ben Brando
Ben Brando

I don’t make very much money, and I don’t think this savings habit would be a good life strategy. This is telling me to subtract substantial tangible daily pleasures from some 75%-90% of my life to add *possible* comfort to the end 10-25% of my life. I would rather eat a satisfying slice of cake after dinner everyday for a week, than go dessertless for six whole days just so I can overindulge on an entire cake on Sunday night. Further I’m gambling on a future scenario that I have no way of reasonably forecasting. The stock market or economy… Read more »

Mark
Mark

I saw an illustration of compound interest in my late teens. The article contained the famous quote on the subject from Albert Einstein. I was impressed. As a result I scraped together every dime I had from summer and part time jobs, mowing lawns, birthday gifts, etc., and invested it all in an established growth and income mutual fund. The amount was $4,500 in 1972. I have never touched it and reinvested all dividends and capital gains. Today it is worth $750,000.

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