The Uninterrupted Compound Growth Curve
"The greatest power on earth is compound interest." -Albert Einstein
Introduction
Compounding is a great way to grow your money over time. By reinvesting earnings (e.g. - dividends, interest or capital gains) you are able to earn in the future not only on the original investment but also on the re-invested earnings. Essentially, you are increasing the amount of your investment moving forward without making a contribution directly from your wallet. Compound interest works on both assets and liabilities. While compounding boosts the value of an asset more rapidly, it can also increase the amount of money owed on a loan, as interest accumulates on the unpaid principal and any previous interest charges. Simple interest differs from compound interest in that it only the principal earns interest each period. While all earnings are good, not all earnings were created equal! Understanding how the growth curve for compounding interest works is essential. It will help you realize the value of this concept as well as the actions that can kill its momentum.
What is Compounding?
To illustrate how compounding works, let’s look at two examples. First, simple interest. Simple interest pays interest only on the amount of principal initially invested or deposited. For example, if $10,000 is deposited with 5% simple interest, it would earn $500 each year ($10,000 x .05=$500).
This is in contrast to compound interest which pays “interest on interest”. Suppose $10,000 is held in an account that pays 5% interest annually. After the first year the total in the account has risen to $10,500, as a result of $500 in interest being added to the $10,000 of principal. In year two, the account realizes 5% growth on both the original principal and the $500 of first-year interest, resulting in a second-year gain of $525 and a balance of $11,025. This increasing return would continue and after 10 years, assuming no withdrawals and a steady 5% interest rate, the account would grow to $16,288.95.
Source: https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator*
Another concept of compounding is the Rule of 72. This term refers to the notion of how long it is estimated for an investment or savings to double in value if there are compounding returns. The rule states that the number of years it will take to double is 72 divided by the interest rate. So, if the interest rate is 5% with compounding, it would take around 14 years and five months to double (14.4 years).
CAGR – Compound Annual Growth Rate
While not essential to understanding the growth curve, it is worthwhile to briefly discuss CAGR (or you can skip to the next section if you want 😊). The compound annual growth rate isn’t a true return rate, but rather a representational figure. It is a number that describes the rate at which an investment would have grown if it had grown at the same rate every year and the profits were reinvested at the end of each year. This sort of performance is unlikely, however, it can be used as a comparative tool so investment performance may be more easily understood compared to alternative methods.
Imagine you invested $10,000 in a portfolio. In 2019 you earned 30%. In 2020 you earned 7.69%. And in 2021 you earned 35.71%. (Sign me up to that one!) Your investment is now worth $19,000. On an annual basis, the year-to-year growth rates of the investment portfolio were quite different. On the other hand, the compound annual growth rate averages the annual returns, accounting for the previous year’s performance as a part of it. The CAGR over that period was 23.86%. The formula for this is beyond the scope of this article, however one of many sites you can use to calculate this is
This formula can be manipulated to analyze compounding interest in multiple ways. One such way to use it is to help project what rate of return would be needed, over a specified period, based on certain assumptions, to achieve a specific future value. For example, imagine that an investor knows that they need $50,000 for a child’s college education in 18 years, and they have $15,000 to invest today. How much does the average rate of return need to be to reach that objective? The CAGR calculation can be used to find the answer to this question.
The most important limitation of the CAGR is that because it calculates a smoothed rate of growth over a period, it ignores volatility and implies that the growth during that time was steady. Returns on investments are uneven over time, with limited exceptions. Also, the CAGR does not account for when an investor adds funds to a portfolio or withdraws funds from the portfolio over the period being measured. For example, if an investor had a portfolio for five years and contributed money to the portfolio during the five-year period, then the CAGR would be inflated. The CAGR would calculate the rate of return based on the beginning and ending balances over the five years and would essentially count the deposited funds as part of the annual growth rate, which would be an inaccurate portrayal of the actual return on the investment
The Compound Curve - The Snowball Effect
Compounding is often referred to as the "snowball effect" because it can cause investments to grow at an exponential rate. If you withdraw the earnings on an investment each year, you end up with a simple interest equivalent. Conversely, if you leave it invested, you can potentially maintain the momentum of the curve, which like a snowball rolling down a snowy hill, continues to grow. If you want to take advantage of one of the ways you can make your money work for you, a smart strategy is to start investing early and let the compounding growth curve work its magic.
Take a look at this curve and notice how steep it gets over time. That’s because the interest is compounding! It illustrates two things. First, the small action of reinvesting earnings over time can potentially lead to major financial gains. Second, the earlier you start investing, the greater the effects of compounding will be. It is equally important to realize that a small interruption to these two strategies can significantly impact your investment returns.
Overall, the compounding growth curve is one of the most powerful forces in finance. With a sound strategy and a bit of patience, you can potentially achieve great financial success over the long term.
The Main Problem – You can’t have your cake and eat it too!
All this stuff sounds great until you realize that not everyone can afford to just let their money sit forever! Most people need the money now or at some point in the future. Once the money is spent you can try to start saving again, but the momentum of the growth curve has been stopped and you must start all over again.
Imagine there was a way to save money and spend it too! A way to let your money compound for the rest of your life while also retaining the ability to spend what you need as you need it! That’s one aspect of what I call Multitasking Money! What are you waiting for? If you want to learn more, keep reading through the Multitasking Money Blog Series.
By Alan J. Mendlowitz, RICP, CRES
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