Your financial goals could seem distant, but it is never too early to begin making progress toward them. If you start investing as soon as possible, you can minimize the amount you need to save each year to reach your goals. This is due to the power of compound returns.
What is Compounding?
Compounding occurs when you repeatedly increase a number by a percentage. In finance, this term usually refers to increasing a dollar amount by a return percentage over a series of months or years.
Compound interest (also known as compound returns) means that you earn interest on your interest. While this might sound confusing, the concept is easy to understand with a simple example.
Imagine you were given $100 and a choice between two returns – $10 per year or 10% per year. You might think that these would yield the same result, since 10% of $100 is $10. But when the 10% return is compounded, you see the difference.
As you can see, when returns are compounded, you earn an additional $6.41, or 4.6%, in this example. While the dollar amount is small and length of time invested is short in this scenario, the power of compounding returns is clearly visible. It becomes even more apparent when applied to a longer time horizon.
Compound Returns Can Help You Reach Your Financial Goals with Less Money Out of Pocket
If you invest a little each year, beginning as early as possible, you can harness the power of compound returns to maximize the size of your portfolio over the long term. When your returns are compounded over several decades, you can invest significantly less each year and achieve similar results — with all other factors remaining consistent.
To illustrate, consider this simplified example. If you invested $10,000 this year and those funds earned an annual return of 10%, you would end the year with $11,000. If you did the same next year, you would earn a total of $2,100 in interest – $1,100 on the previous year’s balance, plus $1,000 on this year’s deposits. This represents and additional $100 in returns that would not have been possible without compounding.
Over the long term, you would continue to earn interest on both your contributions and accumulated interest, allowing your portfolio to grow far more quickly. At the end of 30 years, you would have deposited $300,000 and earned $1,509,434 in returns, for a total portfolio value of $1,809,434.
On the other hand, to achieve the same $1.8 million portfolio in half the time with the same 10% annual return, you would have to contribute about $51,750 per year for 15 years. In this case, your total contributions would equal $776,250 and your returns would be just $1,032,399.
See below for a graphical representation of these examples:
How To Take Advantage of Compound Returns
To make the most of compounding returns, start investing as early as possible. Even if you can’t contribute tens of thousands of dollars each year, the power of compound returns can help your portfolio grow over the long-term.
Choosing the right investments for your situation is another important factor to consider when attempting to take advantage of compounding returns. An experienced wealth manager can help you create a custom portfolio that matches your risk tolerance and unique goals.
You may think that you need to reach a certain threshold before a financial advisor will help you manage your portfolio, but there are advisors who can build a custom portfolio with no minimum investment amount. With a personalized portfolio, and a financial partner you can trust, you can harness the power of compound returns to turn your financial goals into a reality.
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