FCW's Friday Financials column looks at the simple but effective power of compounding your savings over time
Three in 10 Americans think their best chance to end up with at least half
a million dollars in their lifetime is to win a lottery or sweepstakes,
according to a recent poll by the Consumer Federation of America.
But with the odds of winning a lottery at one in 10 million to 20 million,
people are 10 to 20 times more likely to drown in their own bathtubs, according
to figures from the National Safety Council.
Many people don't realize that they can dramatically increase their
odds of accumulating half a million dollars through something far less visible,
but far more powerful, than a lottery: compounding.
Here's a question the Consumer Federation of America asked in its poll:
If you invested $25 a week for 40 years and earned a modest 7 percent on
that money, how much would you have at the end of 40 years? Did you guess
more than $150,000? Only one-third guessed that high. The answer is $286,640.
Double that $286,640 by investing $50 a week and you pass the half million-dollar
Why is compounding so powerful? The concept is simple. Compounding is
when you earn money not only on the money you put into a savings account
or an investment, but also on the earnings themselves. Say you put $100
into a money market account earning 5 percent. At the end of one year, you
have $105 (the total would be a little higher if the account is compounded
daily or weekly). The next year you earn 5 percent on the $105, not just
the original $100. The account finishes the second year with $110.25. At
the end of 10 years, the account will have grown to $163 without you ever
kicking in another dime (taxes are not figured in here).
As the example shows, it takes a while for compounding to get up a head
of steam. That's why people often overlook its power and how small contributions
can grow to large amounts.
Here's a more dramatic illustration. Say you are a participant in the
Thrift Savings Plan (TSP) and invest $2,000 each year. If you do that for
seven straight years and then stop, at 8 percent interest a year, your $14,000
in contributions grows to $20,057 at the end of 10 years. During the next
10 years, the account's value shoots up to $61,491. By the end of 40 years,
the $14,000 has grown to $286,609!
This illustrates not only the power of compounding, but also the devastating
cost of delay. Say you don't put any money in the first seven years. In
the eighth year, you put in $2,000 and every year after that. It would take
you 20 years of annual $2,000 contributions before the total amount in your
TSP account would equal the sum in a TSP account to which you started contributing
seven years earlier and then stopped.
The power of compounding is magnified by higher returns. Say you put
$100 a month into a money market earning 5 percent. At the end of 40 years,
you'll have $153,238 (again, not counting taxes). Invest $100 in an IRA
earning 8 percent and the account will reach $351,428. That's more than
double the earnings at 5 percent, although the average rate of return did
Compounding works best if you leave the money alone. American investors
tend to be "fidgety." The Boston-based financial research firm of Dalbar
Inc. found that investors who bought and held the same stock mutual funds
over 15 years earned an annual average of 17.9 percent. But investors who
moved in and out of their stock mutual funds every three years on average
earned an annual average return of 7.25 percent. If these investors were
putting in $100 tax-deferred a month in these funds, the investors who held
on for 15 years would have earned roughly $57,000 more than the investors
who changed funds every three years.
Many people who pin their dreams on winning the lottery probably feel
they don't have money to invest. Yet it's not uncommon for aggressive lottery
players to spend $25 or more a week attempting to hit the jackpot. They
just don't realize they could make a better bet letting that $25 compound.
This column is based on information obtained from the Financial Planning
Association, the membership organization for the financial planning community.
To get help from a qualified investment professional, it's advisable to
consult a certified financial planner (CFP).
—Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser. He can be reached at firstname.lastname@example.org.
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