Investing Basics: The Power of Compounding

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Narrator: With a little bit of interest and a lot of time, compound interest can help grow a portfolio significantly.

Compound interest is reinvesting earned interest back into the principal of an investment.

As you reinvest interest on top of interest, your investments can grow exponentially over time.

Exponential growth is a result of letting interest compound over time.

This idea can be a little abstract, so let's look at a hypothetical scenario to better understand the potential power of compound interest.

On-screen text: Disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.

Narrator: Suppose there are two investors who have a starting balance of $10,000 each. They both decide to buy the exact same investment on the same date. And they both plan to hold their investments for 30 years.

But one investor plans to withdraw the interest at the end of each year, while the other plans to reinvest the interest and let it compound.

Let's fast forward 30 years to see the difference in potential returns. In this example, let's suppose that the investment earned 7% per year.

The investor withdrawing interest every year would've earned $700 per year. Over 30 years, the earnings would've totaled $21,000.

But let's see how much of a difference reinvesting the interest could've made.

The investor who reinvested the interest would've possibly amassed $76,123 over the 30-year period. This is more than triple the returns of the other investor. This example illustrates the power of compound interest.

Now, let's take it to another level and discuss the importance of time.

On-screen text: Disclosure: For illustrative purposes only. All investments involve risk, including loss of principal and interest invested.

Compounding over a long period of time can potentially lead to significant growth of an investment.

Let's look at another hypothetical example to understand how important time is to compounding.

Suppose two investors have portfolios worth $100,000 each. The portfolios hold identical investments. Each year, both investors save and invest an additional $10,000. And let's assume that with compounding, their portfolios grow 7% per year.

One investor needs the money to retire in 15 years. The other will need the money to retire in 30 years.

Let's see what a difference 15 years can make.

At the end of 15 years, the investor's portfolio would have grown to $527,193.

Now, let's see how much the other investor would've earned.

As you can see, the additional 15 years of compounding resulted in their portfolio growing to $1,705,833. That's over three times the return of the other investor.

Now that you understand how time can impact growth, let's discuss three ways you can harness the power of compounding.

The first step, and perhaps one of the most important, is to start investing early. The earlier you start, the sooner you can start taking advantage of time.

On-screen text: Disclosure: A capital gain is a profit made from selling an investment for more than was originally paid for it.

On-screen text: Disclosure: A dividend is a distribution paid by a company to its shareholders.

Narrator: The next step is reinvesting earnings. When it comes to investing, earnings are typically in the form of capital gains and dividends.

On-screen text: Disclosure: Discuss with your broker the fees that may be involved with reinvesting earnings.

Narrator: Some brokers may allow you to automatically reinvest these earnings.

Or you may choose to simply buy different investments.

The final step is to avoid one of the biggest obstacles many investors face—taking excessive risks that can lead to large losses.

After all, compounding only works if you're earning on your investments.

Of course, consistently earning a profit is easier said than done because investments sometimes make money and other times lose money.

You can't guarantee your investments will make money, but you can avoid taking excessive risks that may lead to large losses.

Measures such as allocating your portfolio across different asset classes and diversifying your portfolio within each asset class can help reduce some of the risk in a portfolio. However, asset allocation and diversification do not eliminate the risk of loss.

To potentially help avoid large losses, resist the temptations of taking excessive risks or not taking any risk and staying on the sidelines.

Because when it comes to compound interest, slow and steady can be a highly effective approach.

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