Guide to Online Investing



Learning Section Compounding

Learning Section
  THE BIG 10 GUIDE
  GIVE YOUR GOALS A LIFE
  THE POWER OF THE EQUITY ENGINE
COMPOUNDING
  RE-THINKING RISK
  IS THERE A "BEST TIME" TO INVEST?
  THREE BASIC TYPES OF INVESTMENTS
  ROCKY ROADS
  DOLLAR-COST AVERAGING
 

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When asked what he considered mankind's greatest invention, Albert Einstein's reply was: "compound interest." Who are we to argue with Einstein? Take a look at this 8th wonder of the world…



Two types of interest: Simple vs. Compound

Simple interest is calculated using only your initial investment. Let's say you invested $1,000 at 7% simple interest. In the first year, you'd receive a $70 interest payment (7% of $1,000). In the second year, you'd receive another $70 (7% on your original $1000 investment). In the third year, another $70…and so on.

Compound interest - the kind that applies to most investments -- is calculated based on your original investment PLUS any interest you've already earned. Lets go back to that $1,000 invested at 7 percent and lets say - like before -- you receive interest payments annually. In the first year, your investment would earn that same old $70 bucks (7% on $1,000). But here's where it takes off: In the second year, your interest income would be $74.94! That's 7% interest based on your initial $1000 investment AND the $70 you earned the first year. (Okay, an additional $4.94 may not seem like great shakes to you. But take a look at how this difference really begins to add up by clicking below.)

One more thing you should know: Interest can be compounded at all different time periods…from annually to daily. The more often interest is compounded, the greater the returns.


Year Simple Interest Compound Interest
Year 1 $1,070.00 $1,070.00
Year 2 1,140.00 1,144.90
Year 3 1,210.00 1,225.04
Year 4 1,280.00 1,310.79
Year 5 1, 350.00 1,402.54


While the numbers in our example aren't huge, you can see how compounding interest can amplify returns. Imagine the effect on your portfolio when (hopefully) larger numbers are involved!



Two factors affect your rate of compounding:
  1. Your rate of return
  2. The length of time you'll invest.
The table below can help you see how compounded interest snowballs over time.

Say you invest $1.00 each year for 5 to 30 years…

The following factors are the rate at which your money would grow over time -- invested at various rates of return (interest is compounded annually).


Interest Rate Years Invested
  5 years 10 years 15 years 20 years 25 years 30 years
4% $5.42 $12.01 $20.02 $29.78 $41.65 $95.03
6% $5.98 $13.97 $24.67 $38.99 $58.16 $83.80
8% $6.34 $15.65 $29.32 $49.42 $78.95 $122.35
10% $6.72 $17.53 $34.95 $63.00 $108.18 $180.94
12% $7.12 $19.65 $41.75 $80.70 $149.33 $270.29


For example, if you invested $1.00 at the beginning of each year and it earned 4% interest for 20 years it would be worth $29.78. Now lets scale it up. Say you invested $1,000 at the beginning of each year for the same time frame at the same interest level. $1,000 x 29.78 = $29,780!

Let's try one more example. Say you have 5,000 to invest and you can add $5,000 at the beginning of each year. Lets also say you choose a stock mutual fund that has an average annual total return of 10% (Remember, there's no guarantee the fund will continue to perform at this rate. It could do worse - or even better.) After 5 years, you may have $XXXXX (5,000 x Factor). After 10 years your investment could be worth X. And so on.

Now that you see the beauty of compounded interest over time…we're ready to move on to a less popular subject: Risk. Don't worry…it's not as bad as you think…


Continue to Re-thinking Risk
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