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The magic of compounding
By Brett Klasko 
Sunday, January 7, 2007
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Wouldn’t you just love to sit back and watch your money multiply without ever adding a penny? Your dream has come true (not only can StudentSavvy educate you, we can also make dreams come true, what’s next?). Welcome to the world of compounding.
Compounding is actually a very simple concept. In its most basic terms, compounding is when you make money on your investment returns. So, you’re already making money on your initial investment, but with compounding you then make money on that investment’s returns or gains.
Confused? Let’s try an example. Cathy baby-sits for a year when she’s 14 years old. By her 15th birthday, Catchy has earned exactly $1000 from the past year. She decides to put the money into a savings account at her local bank, which happens to offer 4 percent interest each year. At the end of one year, Cathy’s initial $1000 is now worth $1040 (calculated by multiplying the initial $1000 by .04 – the interest). The next year, Cathy earns 4 percent on the new value of $1040, which would then total $1083 ($1040 x .04). Not much.
But let’s say Cathy forgets about the money and it sits in that account for 25 years. At the end of 25 years, she would have $2713. Not bad but you’re not falling out of your seat… yet!
Let’s say Roger works at McDonald’s for a year when he’s 14 years old. On his 15th birthday, at which point he has earned a total of $1000, he invests his money into a blue chip stock, say McDonald’s (he liked his job). Assuming McDonald’s gains 12 percent each year (which is about average for most blue chips over the long run), at the end of 25 years, Roger would have $19,788. Without the art of compounding, Roger’s $1000 would only be worth $4000. Looks a little better, eh?
Since one dream just came true, let’s dream a little more. Let’s say Emily works at The Gap from age 15 to 21 (high school and college). Since Emily is a busy girl, she can’t work many hours and only makes $100 per month. But Emily likes to have fun, so she spends $75 of that each month, leaving her with just $25 a month. She decides to put the extra $25 each month into McDonald’s stock (based on Roger’s advice) using a direct stock purchase plan.
Once Emily’s out of college, she continues to invest just $25 a month into her McDonald’s stock until she stops working at the age of 60. When she turns 60, she decides to take the money out of McDonald’s to use toward her retirement and finds $536,367 in her stock. During those 45 years, she only contributed $13,500 total ($25 per month x 12 months x 45 years). If Emily waits an extra 5 years before taking her money out (at age 65), her investment will be worth about $1 million.
Let’s revisit Roger for a second. If Roger had kept his $1000 in McDonald’s until he is 65 (50 years), his initial $1000 investment at the age of 15 would be worth nearly $400,000. Just imagine what would happen if we combined Roger’s initial $1000 investment with Emily’s $25 per month investments… $1,368,041 (I couldn’t resist).
The more money you put into the stock market or a savings account and the sooner, the more money you will have later on in life. Try the calculator out in the Useful Links section below, some of the possibilities are mind-boggling.
As a young investor, time is on your side. Take advantage of it! Compounding is possibly the single most important reason to start investing right now. Everyday you are invested, your money is working for you. Through patience, time, and compounding, you can become a millionaire by retirement.
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