Hit the jackpot with compounding

FCW's Friday Financials column looks at the simple but effective power of compounding your savings over time

"What are the odds of dying?"

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

mark.

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

not double.

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 miltzall@starpower.net.

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