Last week, I talked about the 4 financial pillars. This week, I want to continue our 101 on financial well-being series and want to talk about a simple but overlooked concept that when understood, amazes people. Understanding the power of compounding is fundamental to your financial wellbeing and building wealth. As a concept, this goes beyond even financial wellbeing. So, let’s talk about this!
Let’s start with the basics:
Compounding goes back to that concept we learnt back in school about compound interest. But for purposes of today, let’s just think of compounding in this way – when you save or invest a sum of money, it earns returns in the form of interest or dividends or other forms of return. This return gets added to your original sum and compounds the returns further. Using a simple example, it looks like this:
If you invested $100 today in a savings account with the assumption that it earns a fixed interest rate of 10% annually. If you kept it for 10 years, then it would grow to $236. This in very simple words is compounding. Now let me give an even more extreme example to prove the point:
If you were offered an option of $100,000 today or $1 today with the option of allowing it to double every day for 30 days, what would you pick? If you picked the $100,000, that was a poor choice! ? The $1 by the end of 30 days becomes $536 Million dollars!!! (If you don’t believe me, just put it in a spreadsheet and calculate it out!)
What does all this have to do with financial well-being and building wealth?
If you understand the concept of compounding, you will know that there are 2 things that fundamentally impact the ability of your money to grow and compound:
- Time – the longer the time period, the larger the ability for your money to compound.
- Rate of return – the higher the rate of return, the higher your money compounds.
Simply put, you need to take advantage of the above 2 factors – time and rate of return. There is a saying that goes, “Time in the (stock) market matters more than timing the market.”
SIDE NOTE: It is beyond the scope of this simple article to talk about investment choices that impact the rate of return. Just know that putting money in a savings account gives you a very low rate of return compared to investing in the stock market. But its not as straightforward because all investments carry risk and you have to think about it as a risk-adjusted rate of return. Again, topic for a different day!
The implications of this are obvious and something everyone should follow:
- Invest early on – one of my biggest regrets personally is not investing more in my 401k from the beginning of my career. But its never too late. So, the more you can invest sooner, the better – because time is your best friend when it comes to compounding. I cannot say this enough – the effect of this is staggering! If you started at age 25 and invested $10,000 every year and assumed a 7% rate of return, in 30 years by age 55 that will become almost $1M! On the other hand, if you started at age 40 and invested the same $10,000 per year for a 7% rate of return, you would have earned only a little over $250K! That’s a significant difference!
- Stick to your plan – In challenging bear markets like today or even in bull markets like what we have experienced over the last decade, you will be best served if you continue to invest and stick to your plan. Your time horizon should be the long term and that will over a longer period allow your money to compound. On the other hand, if you stop investing/saving or even worse, withdraw the money, you will lose out on the power of compounding. As Jack Bogle, the late founder and CEO of Vanguard said, “Stay the course!”
Automate all this as much as you can and don’t mess with your investments and you will be amazed to see the results after many years. If you already follow this, you are well on your path to receive the benefits (or have already received) of compounding!
You don’t need a gimmicky, get rich quick scheme to build your wealth. All you need is time and discipline to allow your wealth to compound!
Power of compounding works in other areas of life too!
A final word on this to help understand the concept even better. James Clear in his book ‘Atomic Habits’ talks about the power of making small, incremental changes that compounds over time. I would encourage you to read this article by James Clear illustrating a real-life example: https://jamesclear.com/marginal-gains.
So, let me leave you with these final thoughts on making positive changes in your life through compounding:
- If you are looking to improve your fitness, make marginal improvements on your diet or exercise every day but let them compound over time. Look back after 6 months and be proud of the results!
- If you wish to improve a specific skill, start small and pick small, simple tasks every day that will help you further your skill. After a year you will be amazed at how your skills have compounded over time.
- If you wish to improve your network, start by networking with 1 new person each week and by the end of the year, you would have built quite a rolodex of a network of people!
Compounding works in all areas of life! Just give it time and discipline.
Thank you for reading and I wish you success in your journey to achieve the best thing money can buy – financial freedom to make your choices! Thank you!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
