Compounding returns is the notion of earning money on past earnings. If this is new to you, pay attention—this will be the most important chapter of the book.
Let’s walk through an example:
Say you have $100 in savings, earning 4% per year. After the first year, you’ll have $104—your original $100, plus $4 of earnings. Makes sense, right?
After the second year you’ll have $108.16—another $4 earned on your original $100 savings, plus $0.16 earned on last year’s earnings of $4.
After the third year, $112.49—another $4 on your original $100, plus $0.33 on your last two years earnings of $8.16.
Earnings on earnings, year after year.
It’s hard to believe such a simple concept could be so important. But after many years of investing, the majority of your savings will have come from compound returns, rather than original investments.
Consider this example:
Stephanie is 25, and earns $50,000. Her salary increases each year with inflation. If she saves just 10% of her income, and earns an 8% annual return, then at age 55 she will have invested $280,000, but will have accumulated nearly one million dollars!
The above chart highlights some important concepts.
The power of compounding returns — After 30 years, far more of her final balance of $920,000 comes from earnings ($640,000), than from the money she actually saved ($280,000). Earnings on earnings.
The importance of time — The power of compounding returns comes late in the game. Had she waited five years to start saving—delaying her start by 16%—her final balance after 25 years would have been reduced by 40% ($565,000 compared to $920,000).
The importance of the annual rate of return — What if Stephanie had just put her money in the bank, earning 3% per year? Her final balance would be $420,000—i.e. decreasing her annual return from 8% to 3% decreases her final balance by more than half!