Compounding Can Boost Your Portfolio

Compounding, in terms of finances, is defined as “the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings.” Albert Einstein called it the “greatest mathematical discover of all time,” and the “most powerful force in the universe.” However you look at it, there is no doubt that compounding can add fuel to your portfolio’s growth. The key is to allow enough time to let it go to work for you.

Time and money working together

The premise behind compounding is fairly simple. If an investment’s earnings are reinvested back into the portfolio, those earnings may themselves earn returns. Then those returns earn returns, and so on.

For example, say you invest $1,000 and earn a return of six percent — or $60 — in one year. If you reinvest, combining that $60 with your $1,000 principal, and earn the same six percent the following year, your earnings in the second year would increase to $63.60. Over time, compounding can snowball and really add up.

In another example, say at age 45 you being investing $3,000 annually in an account that earns six percent per year, with earnings reinvested. Ag age 65, your $60,000 principal investment would be worth almost twice as much — about $117,000.

Now consider what happens if you being investing at age 35, using the same assumptions. By 65, your $90,000 principal would nearly triple to just over $250,000. Finally, consider the result if you start at age 20: your $135,000 investment would be worth five times as much — $676,524.

How long will it take?

If you’d like to estimate how long it might take for your investment to double, you can use a principle known as the “Rule of 72.” To use this rule, simply divide 72 by the expected rate of return. For example, if you expect to earn an average of eight percent over time, the Rule of 72 gauges that your investment would double in approximately nine years. (This rule applies to lump-sum investments).

Patience is key

With compounding, the more patience you have, the better off you may be over the long-term. The examples above, assume a steady six percent rate of return each year; however, in reality, no investment return can be guaranteed. Your actual earnings will rise and fall with the changing economic and market condition. For that reason, it’s important to stay focused on the long-term. Over time, the ups and downs may average out, and your earnings can potentially go to work for you.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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