The Benefit of Compounding Interest

Compounding Interest: The Secret to Wealth Growth

Imagine planting a single seed in the ground and watching it grow into a tree that bears fruit year after year. Now, imagine that the fruits themselves turn into seeds that grow into more trees. Over time, you end up with an orchard — all from a single seed. This is the power of compounding interest, often referred to as the “eighth wonder of the world.”

For retail investors, understanding and leveraging compounding can be the key to building wealth over time. Here’s what you need to know.

What is Compounding Interest?

Compounding interest occurs when your investments generate returns, and those returns themselves begin to earn returns. Unlike simple interest, which only pays you on the original principal, compound interest accelerates growth as both your principal and accumulated interest work together to generate even more earnings.

For example, if you invest $1,000 at a 10% annual return:

Year 1: $1,000 grows to $1,100.
Year 2: The $1,100 grows to $1,210 (10% of $1,100).
Year 3: It grows to $1,331.

Each year, the interest earned adds to the balance, creating a snowball effect.

The Role of Time in Compounding

Time is the most critical factor in the compounding equation. The earlier you start investing, the more time your money has to grow. Consider this:

If you invest $5,000 annually starting at age 25 and earn a 7% annual return, by age 65, you’ll have over $1 million.
If you start the same process at age 35, you’ll only have about $500,000 by age 65.

The 10-year delay cuts your total wealth in half, even though you invested the same amount annually.

Reinvestment: The Golden Rule

For compounding to work its magic, you must reinvest your returns. This is why dividend reinvestment plans (DRIPs) and compounding-focused mutual funds are popular among long-term investors.

For example:

A stock that pays a 3% annual dividend can yield much higher returns over time if you reinvest those dividends rather than cashing them out.

Compounding in Different Investments

Savings Accounts: Compounding happens daily, monthly, or annually. While interest rates are usually low, the principle remains the same.
Stocks: Growth stocks, reinvested dividends, and the overall market growth can fuel compounding.
Mutual Funds & ETFs: These are great for compounding through diversified portfolios and reinvested distributions.
Retirement Accounts (401(k), IRA): Tax advantages in these accounts allow for uninterrupted compounding without annual tax drag.

The Rule of 72

To estimate how long it will take for your investment to double, divide 72 by your annual return rate.

At 8% annual return: 72 ÷ 8 = 9 years to double.
At 6% annual return: 72 ÷ 6 = 12 years to double.

This simple rule highlights the importance of earning higher returns and the value of time in compounding.

Beware of the Obstacles

While compounding is powerful, there are barriers to its effectiveness:

Fees: High fees on investments can erode returns. Opt for low-cost index funds or ETFs.
Taxes: Gains taxed annually can slow compounding. Tax-advantaged accounts like Roth IRAs help shield your earnings.
Impatience: Compounding takes time, and the growth is exponential. Stay invested for the long haul.

The Bottom Line

Compounding interest is a simple yet transformative concept. For retail investors, it underscores the importance of starting early, staying consistent, and reinvesting returns. By harnessing the power of time and reinvestment, you can set yourself on a path to long-term wealth.

Start planting your financial seeds today — the orchard you grow may surprise you in the years to come.

If you need the insight of a financial advisor, consider working with a Hazard & Siegel Independent Financial Professional. An Independent advisor will make the best decisions for you because they are not affiliated with an investment company, mutual fund, or specific investment product. Hazard & Siegel Independent Financial Professionals are part of a network of registered investment advisors, insurance professionals, and investment brokers. Our independent financial professionals are available to advise you on planning for your future including paying for college, wealth management, retirement planning, paying for long-term care, estate planning, insurance needs, and wealth transfer.

Hazard & Siegel offer clients the flexibility and choice of both fee-based and commission-based platforms, dependent upon what works best for your plan, and what you are most comfortable with. Both approaches have their advantages, but ultimately you as the client get to decide which fee structure or combination of fee structures work best for you.

Talk to Hazard & Siegel when you need a comprehensive lifetime financial solution.