“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein
When money is invested, it produces earnings that can then be reinvested, so that you receive earnings on your earnings in addition to the earnings on your original investment.
This added boost is the power of compounding, and the longer the money is invested, the more powerful are its effects. Over long periods of time—20, 30, or 40 years—the effects of compounding at different rates can be substantial. For instance, if you invested $10,000 today and it earned 8% annually, you would have $100,626 at the end of 30 years; if it earned 9% you would have $132,676 after 30 years. That’s a $32,000 difference with only a 1% difference in return annually.
In retirement planning, there are advantages of earning higher returns over long time periods. But, keep in mind that small differences in investment return assumptions can turn into large differences in accumulation.
Start early and reap the rewards
“Letting your money work for you is a key component of saving for retirement. Compound interest, dollar cost averaging, tax-deferred savings, and diversification help lower your risk and boost your return on investment over time. Compound interest is the interest on your principal plus interest on the interest you earned previously.
For example, a single investment of $10,000 at 5% compounded annually earns $10,789 in interest over 15 years for a net amount of $20,789. Straight interest would accrue at the rate of $500 per year, $7,500 in total interest, for a net amount of $17,500. When interest is reinvested and compounds at 5%, it adds another $3,298 to the value. That is the magic of compound interest.” Taylor Larimore et al, The Bogleheads’ Guide to Retirement Planning
Compounding gives invested money the ability to grow over time. The Rule of 72 is the number of years needed to double invested money at a given interest rate. Divide 72 by the interest rate…money invested at 10% will double in 7.2 years
Be conservative in your estimates.