The Power Of Compounding

What is "compounding"? Simply put, it is interest earning interest. Why is it 

so powerful? Because as the interest that is earned by the initial capital also 

earns interest, the value of the account grows at a geometric (ever-increasing) 

rate, rather than an arithmetic (straight-line) rate. The higher the rate of return, 

the steeper the curve.



ANOTHER EXAMPLE OF HOW COMPOUNDING WORKS

Two investors have $1,000 each to invest every year in a mutual fund, leaving the dividends to compound. Investor A's fund provides an 8% annual return, while Investor B's fund returns only 4%. While Investor A's rate of return is twice that of Investor B's, over time the increase is significantly more than twice as much. After 10 years, Investor A's gain is 2.23 times greater, and after 20 years, it is 2.63 times greater.

These examples are for illustrative purposes only and are not intended to depict the actual performance of any fund. A mutual fund's investment return and share value will fluctuate.


THREE WAYS TO PUT COMPOUNDING TO WORK FOR YOU

Reinvest dividends
Instead of taking your mutual fund's distributions in cash, instruct your fund to let them remain in your account to purchase additional shares. Most mutual fund companies will allow you to do this at net asset value without paying an additional sales charge.

Invest regularly
Develop the habit of adding to your mutual fund account on a regular basis, perhaps monthly or quarterly. You may be able to have this done automatically by setting up a systematic investment plan with your mutual fund company. By investing regularly you take advantage of a strategy called dollar-cost averaging. Regular investing, however, does not ensure a profit or protect against loss in declining markets.

Make time your ally
The longer your money can work for you, the better compounding works. Consider this: $1,000 invested at 8% earns $80. Left to compound, the original $1,000, plus accumulated interest, will earn $160 in the 10th year, $507 in the 25th year, and $1,609 in the 40th year -- returns of 16%, 51%, and 161%, respectively, on the original $1,000.


HOW LONG TO DOUBLE YOUR MONEY?

The Rule of 72 tells you how long it will take. (Also see Einstein's Rule of 72)

If you study the compound-interest table for any rate of interest, you will find that by multiplying the number of years at which $1.00 becomes $2.00 by that rate of interest, the result is always approximately 72. (If you were to calculate the point mathematically using years and fractions of years, it would be precisely 72.)

Knowing this trick, called the Rule of 72, you can quickly estimate the number of years it will take to double an investment -- or the rate at which your investment must grow in order to double within a stated number of years.

To find the number of years, simply divide 72 by the rate. Or, to find the rate at which your investment must grow in order to double in a specified number of years, divide 72 by the number of years.



Thus, if an investment is growing at a rate of 6% a year, it will double in value in 12 years. At a 10% rate, it will double in 7.2 years. Similarly, if you want to double your money in 4 years, you must invest it at 18%.

It is important to keep in mind that most investments, including mutual funds, do not grow at a steady rate and that the Rule of 72 should only be used as a guide in setting long-term investment goals. Actual performance cannot be ensured, and past performance of a fund is no guarantee of future results.