The Magic of Compounding, the eight wonder of the world.

If you're not the type who enjoys maths, expect this to be boring. It's all about numbers after all. But give me a chance, to show you how money grows.

Compounding depends on three factors:

1. How much you invest
2. How much time it spends growing.
3. Its rate of growth.

An example or two. 

Compounding is growth over time.

It's easier to understand when you consider some examples. Start simple, use 10% annual growth and start small, with $100. Call this year 0. One year later, our $100 has grown by 10%. Since 10% of 100 equals $10, we add that and we have $110. Got that? (Remember, to find 10%, just multiply the number by 0.10. To find 5%, multiply by 0.05. for 25%, by 0.25.)

Year 2, add another 10%. But this time you don't end up with $10. 10% of $110 is $11. So we end Year 2 with $121 ($110 plus $11 equals $121). Year 3, add 10% again, or $12.10. Our new total is $133.10. Here's a table that will make it clearer:

You see, your initial $100 growing, and the amount by which it's growing is also growing. That's compounding in action. In just seven years, you almost doubled your money.

The Growth Rate;

How fast your money grows, from year to year -- is very important.  using $100 again, but compounding at three other rates of growth: 5%, 11%, and 15%. 5.00% is a bank account in some years. 11.00% is the historical average growth per year of the world stock markets for most of the last century. 15.00% is how fast your money might grow if invested in a bunch of top-quality companies that you selected on your own.

If you start with $100, and it grows at 5%, 11%, and 15%, here's how much you'll have after various periods of time. (rounded to the nearest dollar.)

Pretty impressive? Here are some things you should notice or be aware of:

• See how the amount by which the sum grows is increasing as the years go by. 
• Don't let these long time frames put you off. If you're 15 years old now, you probably can't imagine being 55 or 65 and that's reasonable.
• Notice what a huge difference the growth rate makes. Growing at 15% instead of 5%, you'll end up with about four times more money after 15 years. 11% and 15% might not seem so far apart, over 20 years, you'll end up with twice as much money. Stretch that out over 50 years, and you'll have nearly six times more money at 15% instead of 11%.

Interest vs Share Market Returns: 

Keep in mind that not all growth rates are the same. If your bank is paying 6% interest on your savings, that's pretty much guaranteed money. If a bond is paying you 7.50% interest, that's also close to a sure thing. (Interest rates change so you may get 5% in some years and 7% in others.)

The share market is not a sure thing, (and neither are some bonds issued by companies). Share markets fluctuate. There are good years, great years, so-so years, and years we'd much rather forget. Over long periods of time though, markets tend to go up. Over many decades, have averaged around 11% per annum.

Similarly, with companies, many remain strong, others fail. If you invest in solid, growing companies, you can hope to earn maybe 15%, on average, per year. Select one or more companies that turn out to be remarkable growers, you might be higher than 15%.

The Amount of Money You Invest.

 You can now see how money can grow over time, and how much growth rates matter. Now let's turbocharge our figure by upping our start money.

Let's see what happens with $1,000 and it grows at 5%, 11%, and 15%, here's how much you'll have after various periods of time:

Well amazing -- in 50 years, $1,000 becomes $1 million! (If only your grandparents had invested $1,000 for you 50 years ago, eh?) The point of this is just to show the more you invest, the more money you're likely to end up with.

Investing Money Regularly.

Let's tweak these tables one last way, to make them more realistic. After all, how likely is it that you'd invest just $100 or $1,000 in one shot at your age, and add nothing else for the rest of your life? Here's what happens when you invest money regularly.

Investing $1000 initial investment and add $1000 every year, and your little bundle of wealth grows at 11% per year, here's how much you'll have after various periods of time.

Notice how little you put in, versus how much you have. For example, by Year 5, you invested a total of $5000, but you have $6390. By Year 15, you invested a total of $15,000, and you have more than twice that. By Year 35, you invested a total of $35,000, and you have almost 10 times that much!

The most important factor here is time. It's one thing that you, as a teenager, have much more of than any adult. It can be a huge advantage. You don't have to start investing today, or even this year. But if you learn a few things now and get started soon, you can set yourself up to enjoy comfort and security for most of your life.

Remember that you can still enjoy life while you're saving and investing. You can amass great wealth by regularly investing a portion of your income -- not all of it.

Original Article published June 2005