The Power of Compounding

You may have heard of “the power of compounding” or the “power of compound interest.” This phrase, to savers and investors, connotes how a sum of money will grow exponentially over time by the repeated reinvestment of distributions like interest earnings, capital returns, and dividends to the original sum. Each round of reinvested earnings adds to the principal amount you have which yields the next round of earnings. Let’s say, for example, you invest $1,000 in a stock mutual fund (a number of stocks bundled together) or other investment that pays an average 7% return. After a year, the fund should be worth $1,070 – the original $1,000 plus $70 from capital return, dividends or both. After the second year, the account will have grown to $1,144.90 – in other words, $1,070 from the first year + the second year’s interest ($1,070 X 7% = $74.90). Additionally, let’s say our investor after year one keeps investing an additional $1,000 a year for the next 20 years. Assuming the same 7% annual return, the accumulated assets in the stock mutual fund will grow to $40,995.49! This means that from $20,000 ($1,000 a year for twenty years) of contributed savings, the value of the investment will have more than doubled.