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COMPOUND INTEREST The Investment Tipping Point

our first compound interest: 10% of the $1,000 gained in year one, or $100. The next year compound interests accounts for a total of $310. Each year thereaf- ter, the gains generated by compound- ing keep growing, and this portion of the overall return becomes a visible, though still relatively small piece of the portfolio’s value. Starting in year 15, the cumulative amount of compound interest earned exceeds the aggregate amount of interest received. From that point onward, those earnings on earn- ings really take off, driving the majority of the subsequent growth. While the growth of that single $10,000 investment compounded at 10% is impressive, it’s worth noting that the real power of compounding kicks into overdrive when combined with regular additional contributions to your account. This is what makes investing in retirement accounts like IRAs and 401(k)s so attractive. Meet an imaginary 65-year-old investor, Joe, who retired a millionaire at the end of June 2014. Forty years ago, on Wednesday, July 1, 1974, as a 25-year-old with a $12,000 salary (equivalent to about $57,700 in today’s dollars), Joe started investing 10% of his (pretax) paycheck every month into Wellington —a practice he would continue for the rest of his career. Joe stuck with the same employer for his entire career, and was rewarded for his loyalty with consistent, annual 3% raises. The table to the left provides a snapshot of where Joe ended up, and as you can see, Joe did pretty well for himself. His contributions increased each year in concert with his sal- ary, but in the end the biggest slice of his portfolio’s ending value, by a wide margin, came from earnings on those contributions and, importantly, earnings on those earnings. All told, Regular Contributions Kick Compounding Up a Notch

“Compound interest is the eighth won- der of the world. He who understands it, earns it…he who doesn’t…pays it.” —Albert Einstein (maybe) NO ONE DOUBTS that Albert Einstein was a genius, though claims that the quote above about the wonders of com- pound interest and the myriad varia- tions I’ve seen over the years were his are actually unverified. Quotably admired by Einstein or not, compound interest is indeed a powerful wealth builder—and it under- pins my philosophy of spending time in the markets, rather than trying to time them. Since you and I want to be the ones earning compound interest, and not paying it, I thought it would be worth rolling up our sleeves to get a better understanding of what com- pounding is and how it works. So let’s start at the beginning: Compounding is the phenomenon of earning increasing returns on prior gains, over time. You don’t have to make a conscious decision to put the power of compounding to work, though you can make moves that rob you of its benefits. It takes discipline and patience to reap the long-term benefits of com- pounding. For one, you need the dis- cipline to stick with a solid investment plan and to leave your money invested in the market to build on itself over time. Patience is necessary, because early on, the amount you invest far outweighs the amount earned on those initial contributions. But as I’ll show you shortly, those first investments, if held over long time periods, can add up to very significant sums as they build upon themselves. How Compounding Works For a simple example of how com- pounding works, take a look at the chart at the top of this page, which shows the growth of a single $10,000 investment assuming an annual return

In Time, Compounding Creates Wealth

$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $140,000 $160,000 $180,000 $200,000

Principal: Your initial investment. Interest: Earnings gained on the principal. Compound Interest: Earnings made off of previous gains.

Account Value

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Years

of 10% over 30 years. I’ve broken this investment into its three compo- nents: Principal, interest and com- pound interest. In this example, you can see that in the early years, most of the over-all value of the portfolio lies in the original $10,000 investment, or principal (the dark blue area along the bottom). This amount never changes, since no money is being added over time. Gradually, the 10% return earned on the principal (the light blue region in the middle) accumulates at a steady $1,000 per year to match (after 10 years—10 times $1,000 = $10,000) and then exceed the principal. But it’s what happens in the “com- pound interest” area of the chart that is most intriguing (the grey shading on top). Initially, it’s the barest shadow of a line because there is little additional value to compound. Remember, only $1,000 is “added” each year to the portfolio from the 10% return on the $10,000 principal. In year two, we earn

Creation of a Millionaire Starting Age

25 65

Retirement Age

% of Salary Invested

10%

Annual Raises Total Investment

3%

$90,798

End Balance

$1,000,290

% from Contributions % from Investment Returns

9%

91%

12 • Fund Family Shareholder Association

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