Power of compounding

RYAN By Guest Blogger Ryan Lewenza
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“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

The above quote is attributed to the Nobel Prize winning physicist Albert Einstein. So in addition to developing The Theory of Relativity (you may have heard of it…E=mc2), he also had the brilliance to recognize the incredible power of compounding returns, which is the focus of today’s blog post.

Simply stated, compound returns are just returns on returns, and they help to significantly grow your savings over time. For example, say you invest $10,000 and you earn a 6% annual rate of return over a five year period. At the end of year 1 you’ll have $10,600 with your return being the $600. Then in year 2 you’ll earn another $636 ($10,600 x 1.06), with the $36 representing the compounding returns on the original $600 earned in year 1. In the table below take note of the yearly return column, which increases from $600 in year 1 to $757.49 by year 5. That’s compounding returns at work.

Compound Returns at 6% on $10,000 Investment

Source: Turner Investments

Now the magic of compounding returns, and why Einstein called it the “eighth wonder of the world”, is the earlier you start investing, and the longer you’re able to compound the returns over time, the more exponential the returns become.

In the chart below I calculated an investor saving $1,000/month ($12k/year), earning a 6% return, and starting at age 30 (35 years invested), age 40 (25 years) and age 50 (15 years) to retirement age of 65. The investor who starts saving at 30 years old would have a retirement portfolio at age 65 of $1.43 million. The second investor who starts ten years later at age 40 would see their savings grow to only $696,000. So, in this example, if you start 10 years earlier, which equates to an additional $120,000 of savings, it will result in the portfolio being $700,000 higher at the end due to the power of compounding returns. Finally, an investor who drags their heels and waits till age 50 to begin saving would see their savings grow to just $292,000 by age 65.

As you can see in the analysis the key is starting early, continuously saving, and sticking to the long-term plan so that compounding returns can work for you.

The Power of Compounding

Source: Turner Investments. Assumptions: investor saving $1,000/month ($12k/year), earning a 6% return, and starting at age 30 (35 years invested), age 40 (25 years) and age 50 (15 years) to retirement age of 65

Another interesting way to look at compound returns is to calculate the required monthly savings amount at different ages that will achieve a $1 million portfolio by retirement age of 65.

In the chart below, where we look at different starting ages to invest, lets focus on age 25 and 45. If you want a $1 million portfolio at retirement and start saving at age 25, with the portfolio earning a 6% rate of return, you’ll need to save $499/month or $239,520 in total. Compare that to a person who starts saving at age 45, they will need to save $2,153/month or $516,720 in total till age 65 to realize their goal of $1 million. So here’s the easy question for our readers – would you prefer to save $499/month at age 25 or $2,153/month at age 45 to have a million bucks at retirement? I know which one I would prefer.

Monthly Savings to have $1 million in Retirement

Source: Turner Investments. Assumptions: 6% annual rate of return

In just the last week we saw the S&P 500 hit new highs, followed by a big drop on news that the US/China trade deal could be pushed till after the 2020 election. During these uncertain and volatile times when we’re inundated with so much noise we can lose perspective of what’s really important to investing and realizing our long-term financial goals.

At the end of the day, the two most important factors to successful investing are one’s long-term rate of return and the number of years invested. We get so caught up on which hot stocks to buy, when the next bear market may be coming, how much should we have in equities etc., when the simple truth is it’s about time in the market, rather than timing the markets that will determine whether you realize your financial goals.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.

 

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