From Dr. David Eifrig, editor, Retirement Millionaire:
Nearly 30 years ago, I showed my sister how to become a millionaire.
Today, she lives in a house in Bozeman, Montana with beautiful mountain views. She and her husband have the time and money to do most anything they want.
The secret isn’t hard to grasp… But it involves a little bit of math. So it can take some time and patience to understand. The secret is “compounding”…
Respected physicist Albert Bartlett once claimed,
“The greatest shortcoming of the human race is our inability to understand the exponential function.”
The “exponential function” is a mathematical way of explaining compounding. For many folks, our brains tune out when the subject turns to math…
Remember… compounding your capital is simply a way of saying that growth of your money happens over and over again at regular time intervals. For example, say I agree to give you $12 a year on a hundred dollars. At the end of year one, you’d have $112, for a 12% return.
But what if, instead, I say I’ll give you 1% a month.
Our brains say, that’s 12% a year, right? But after Month 1, you have $101 and then after Month 2, you have $102.01. After Month 3, you have $103.03. At the end of the year, you have $112.68. By compounding the money more frequently, you earn $0.68 more in that first year.
That’s because the money you make in each time period is added to the money you started with. And then the next time period’s earned interest includes the “extra” money you made in the preceding period, along with the initial $100. You end up with more and more, because you’re making more and more on each little bit extra earned.
Now imagine you compounded weekly… daily… or even continuously (the math geek’s favorite time period)…
There’s a story about the inventor of the game chess: He was offered any reward he wanted by the king. The inventor asked that one grain of rice be placed on the first square of the chessboard. Two on the second. Four on the third. And doubling each square until the board was full.
It turns out that sort of doubling, just on a 64-square chessboard, compounds massively… and quickly. By the end, the inventor would have had enough rice to cover the earth several inches deep.
Let’s look at an example with cash…
Investor A starts a regular investing plan in an IRA account at age 26. He deposits $2,000 into his IRA each year. He invests this money in a portfolio of safe stocks that pay 10% dividends. He continues these contributions until he retires at age 65.
Investor B is a bit younger and starts investing in an IRA account at age 19. He also deposits $2,000 each year and invests in the same 10% dividend portfolio. However, here’s the amazing thing… Investor B only makes seven contributions. After age 26 (the same age the other investor started), he makes no more payments.
Imagine their stock portfolios show no share-price appreciation. They just crank out 10% dividends each year. On their 65th birthdays, the two investors compare the balances in their accounts.
| Investor A | Investor B | |
| Contributions | $80,000 | $14,000 |
| Account Balance at 65 | $973,704 | $944,641 |
| Earnings Actually Made | $893,704 | $930,641 |
| Return | 11-fold | 66-fold |
Even though Investor B only made seven contributions, he ended up making more money than Investor A, who made 40 contributions. The trick is, Investor B started seven years earlier than A. So on the day Investor A made his first contribution, Investor B had already accumulated $22,959 and his portfolio was earning $2,296 a year in dividends.
As you can see, using time to your advantage is a critical ingredient in compounding. The more years you give it, the more your money mushrooms.
That’s the whole point of compounding… you earn money on the money you’ve earned.
There’s only one thing you need to do to take advantage of compounding. Start now.
The only way you can use compounding to your advantage is through time. A dollar invested today is more valuable than one invested tomorrow. And it’s a lot more valuable than one invested next year.
Let me say it again. Don’t wait. Start investing today and let compounding start to take over. No matter your age or your wealth, it works.
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