What Is Compound Interest?
Compound interest is interest earned in a savings account or on certain types of investments, such as certificates of deposit (CDs) or fixed annuities. You can earn interest on the principal and the interest added over time.
Compound Returns
Compound returns apply to dividends, capital gains, and other investment gains. This concept is commonly used when discussing stocks, mutual funds, and other investment vehicles.
Impact of Compound Interest
Compound interest can work for or against you:
Compound interest works in your favor when the market goes up, and your investments increase in value.
Conversely, compound interest works against you when you carry a credit card balance, increasing the amount you owe for products and services.
The more often interest compounds, the greater the impact.
Tips to Receive Compounding Returns
These tips can help you invest and benefit from compound interest:
Invest Early
As the popular saying goes, “It’s not about timing the market. It’s about time in the market.” Time fuels the power of compounding.
For instance, consider the difference 5 years can make when saving for retirement:
Investor A saves $6,000 at the beginning of each year, starting at age 25.
Investor B saves $6,000 at the beginning of each year, starting at age 30.
Each investor continues saving until they reach age 67.
Each investor earns an average of a 7% return.
Because of the 5-year difference, the investors retire at the same time with different results:
Investor A invested $252,000 and retired with approximately $1.5 million in their account.
Investor B invested $222,000 and retired with just over $1 million.
Investor A grew their savings by approximately 500%.
Investor B grew their savings by more than 350%.
Start investing now, even with small amounts, to take advantage of compounding interest.
Invest Regularly
Regularly investing supports financial success. For instance, if Investor A started investing at age 25, stopped 10 years later, and didn’t contribute again, their account balance would be approximately $713,000. Investing $60,000 and ending up with $713,000 is a strong return on investment (ROI). However, it’s substantially less than investing over a longer period.
Regular investments decrease risk through dollar-cost averaging:
Investing smaller amounts at regular intervals rather than a large lump sum lets investors take advantage of market ups and downs.
Purchasing the same dollar amount of an investment lets you buy more shares when the prices are down and fewer when the prices are up.
This strategy helps investors avoid purchasing many shares before the prices drop and fewer shares before prices rise.
Dollar-cost averaging can lead to paying less per share on average over time.
You likely use dollar-cost averaging if you’re investing through a 401(k) or 403(b) plan at work. Keep in mind that dollar-cost averaging does not guarantee a profit or protect against loss in declining markets.
Diversify
Although individual stocks can generate short- and long-term returns, they carry more risk than other investments. While company stock can lose all its value, the overall market has not. Therefore, investing in diverse companies is recommended:
Any losses incurred by one investment can have a lesser impact on your overall portfolio.
When one or more stocks decrease in value, others can rise.
Although diversification does not guarantee gains or prevent losses, it can improve returns based on your risk tolerance.
Mutual funds, index funds, exchange-traded funds, and target-date funds are popular alternatives to investing in stocks.
*This information is for educational purposes only.
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