By Selena Maranjian
The world is full of empty promises. Advertisements
tell us to buy an
amazing cream because it will make us beautiful, or to buy that
weird-looking contraption because it will tone our muscles and make us
popular.
And here comes the Fool, with another promise. Invest money now and we'll
help make you a millionaire, or at least comfortably well-off in your
adulthood. Gee, that sounds even less believable than the beauty cream,
doesn't it? But it's true. You can print this out and take it to your math
teacher, and she can verify it.
If you leave your money to grow for a long time, $100 can turn into a
million dollars. No, seriously. How? Through compounding.
The Magic of Compounding
If you're not the type who enjoys math class, who delights in solving for
X and figuring out how long it will take a plane to get from Los Angeles
to New York if it's going 650 miles per hour, you might expect this
section to be boring. It's all about numbers, after all. Give it a chance,
though -- these numbers will show you how money grows and how millionaires
are made.
Just how magical compounding can be depends on three factors: How much
money you invest
How much time it spends growing
Its rate of growth
Let's look at some examples, to see how it can work.
Compounding is when something grows over time, and the amount by which it
grows is also growing. It's much easier to understand when you consider
some examples. (Math alert! Math alert! Keep reading, though -- it's just
multiplication, and it's very important stuff.) Let's start with a simple
example. We'll use 10% as our annual growth rate and start small, with
$100. Let's call this Year 0, when we start with $100. One year later, in
Year 1, our $100 has grown by 10%. Since 10% of 100 equals $10, we add
that to our money and end the year with $110. Got that? (Note: Remember,
to find out what 10% of anything equals, just multiply the number by 0.10.
To find 5%, multiply by 0.05. For 25%, by 0.25.)
In Year 2, we add another 10%. But this time you don't end up with $10.
Ten percent of $110 is $11. So we end Year 2 with $121 ($110 plus $11
equals $121). In Year 3, we add 10% again, or $12.10. Our new total is
$133.10. Here's a table that will make it clearer:
Year Start with Add 10%
0 $100
$10
1 $110
$11
2 $121
$12.10
3 $133.10
$13.31
4 $146.41
$14.64
5 $161.05
$16.11
6 $177.16
$17.72
7 $194.88
$19.49
8 $214.37
Do you see what's happening? Your initial bundle of $100 is growing, and
the amount by which it's growing is also growing. That's compounding in
action. In just eight years, you doubled your money. If you had just added
10% of $100 each time, that would have been $10 every year, and you'd have
ended up with $180. But since your money was compounding, it grew faster.
If this doesn't seem magical enough for you, here's a continuation of the
earlier table, showing certain years that are farther out:
Year Start with Add
10%
8 $214.37
$21.44
10 $259.37
$25.94
15 $417.72
$41.77
20 $672.75
$67.28
25 $1,083.47
$108.35
30 $1,744.94
$174.49
35 $2,810.24
$281.02
40 $4,525.93
$452.59
45 $7,289.05
$728.90
50 $11,739.09
$1,173.91
Now that's magical, isn't it? Here are a few key things to notice:You
started with just one single investment of $100. In Year 25, your wealth
grew by $108! In that single year, you made more than your entire initial
investment. And the following year, you made even more than that.
Notice how large the total gets. You started with $100, but in 50 years,
that's become almost $12,000. (A stickler might point out that thanks to
inflation you won't be able to buy as much stuff in 50 years with that
$12,000 as you could buy with $12,000 today. But then, today you just have
that $100. You're still coming out way ahead.)
Notice that the longer you let your money compound, the more massive each
year's growth becomes. In the first years, you just added $10 or $20 or
$30 per year. But after 25 years, you're adding hundreds each year.
Compounding gets more powerful the longer it's left to work.
The Growth Rate
If you're not yet finding this fascinating, then perhaps the next few
tables will do it for you. Remember that we used a growth rate of 10% in
our example above. The growth rate -- how fast your money grows, on
average, from year to year -- is very important. Let's start over, using
$100 again, but compounding at three other rates of growth: 5%, 11%, and
15%. Five percent is what you might earn in interest in a bank account in
some years, or on a CD (certificate of deposit) or on some bonds. Eleven
percent is the historical average growth rate per year of the stock market
for most of the last century. Fifteen percent is how fast your money might
grow if it were invested in a bunch of top-notch 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. (The pennies have been rounded
off to the nearest dollar.)
Year 5% 11%
15%
5 $128 $169
$201
10 163 284
405
15 208 478
814
20 265 806
1,637
25 339 1,359
3,292
30 432 2,289
6,621
35 552 3,857
13,318
40 704 6,500
26,786
45 899 10,953 53,877
50 1,147 18,456 108,366
Pretty impressive, eh? Here are some things you should notice or be aware
of: Again, see how the amount by which the sum grows is increasing as the
years go by. For example, growing at 11%, your total increases by around
$200 between years 10 and 15. But in a later five-year period, between
years 40 and 45, your total grows by more than $4,000!
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. That's reasonable. Soon we'll
discuss how you can move things along more quickly. Just let these tables
show you how compounding works and how it gets more and more powerful as
the years go by.
Finally, notice what a huge difference the growth rate makes. If your
money is growing at 15% instead of 5%, you'll end up with about four times
more money after 15 years. Even though 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%.
Notice that, growing at 15% per year, a single $100 investment can turn
into more than $100,000 over 50 years.
Interest vs. Stock Market Returns
Keep in mind that not all growth rates are the same. If your bank is
paying 3% interest on your savings, that's pretty much guaranteed money.
If a savings bond is paying you 5% interest, that's also darn close to a
sure thing. (Interest rates change over time, though, so your bank might
be paying you 1% in some years and 6% in others.)
The stock market, however, is not a sure thing, and neither are some bonds
issued by companies. Stock market returns fluctuate. There are good years,
great years, so-so years, and years we'd much rather forget. Over long
periods of time, though, the stock market tends to go up. Over many
decades, it has averaged an annual 11% return.
Similarly, with companies, many remain strong for decades or a century.
Others fail. If you select and invest in solid, growing companies, you can
hope to earn as much as 15%, on average, per year. If you select one or
more companies that turn out to be remarkable growers, such as Microsoft,
the average growth rate for your investments might be higher than 15%.
In general, the more certain the growth rate, the lower it will be. The
more iffy it is, the higher it will be. We'll cover these topics in more
detail later. For now, just understand that most growth rates are not sure
things. (That's okay, though. You can still make a lot of money by
investing.)
The Amount of Money You Invest
You should now have a sense of how money can grow over time, and how much
growth rates matter. Now let's turbocharge our results by upping how much
money we start with. Instead of starting with an initial investment of
just $100, let's see what happens with $1,000.
By the way, if $1,000 seems like an awful lot to you, realize that it's
really only $20 per week. Accumulating $20 per week to save isn't as
difficult as you may think. In another article we offer you a bunch of
good ideas.
If you start with $1000, and it grows at 5%, 11%, and 15%, here's how much
you'll have after various periods of time:
Year 5% 11%
15%
5 1,276 1,685
2,011
10 1,629 2,839
4,046
15 2,079 4,785
8,137
20 2,653 8,062
16,367
25 3,386 13,585
32,919
30 4,322 22,892
66,212
35 5,516 38,575 133,176
40 7,040 65,001 267,864
45 8,985 109,530 538,769
50 11,467 184,565 1,083,657
Lookie there -- 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 table is just to show you: the more you invest, the more money you're
likely to end up with.
Is Your Head Hurting?
Is all this math stressing you out? We're almost done. This is extremely
important stuff -- stuff that could change your life. Don't think of it as
just math -- think about what the tables represent. They show you how
small sums of your money can grow into large sums. You can start with
enough money to buy a CD player, and end up with enough to buy a car or a
house or a trip around the world.
Many adults find that these tables make their heads hurt, too, but for a
different reason. It's because when they realize what these tables are
saying, they start banging their heads against a wall, wishing they'd
known about this stuff when they were younger.
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, then add nothing else for the rest of your life? Here's what
happens when you invest money regularly.
Investing $100 Each Year
If you start with an initial investment of $100 and add $100 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.
Year Amount
5 $639
10 1,700
15 3,488
20 6,500
25 11,576
30 20,129
35 34,541
40 58,827
45 99,749
50 168,706
Notice in the table above how much you put in, versus how much you have.
For example, by Year 5, you invested a total of $500, but you have $639.
By Year 15, you invested a total of $1,500, and you have more than twice
that. By Year 35, you invested a total of $3,500, and you have almost 10
times that much!
Compare this table with the earlier table showing you how a single $100
grows over time at 11%, and you'll see some interesting things. One number
that pops out is $6,500. That's how much you'll have after 40 years, if
you invest just one $100 bill. But if you're plunking down $100 each year,
you'll reach $6,500 in just 20 years -- half as long! See the power of
investing regularly? Even with these very small amounts, it makes a huge
difference.
As you might guess, if you want to know how this would work if you
invested $1,000 each year instead of $100, just multiply the numbers in
the table above by 10.
The Keys to Compounding
To summarize, remember that the power of compounding depends on:How much
you invest (and how regularly)
Your growth rate
How long you let your money grow
It's likely that none of the examples above reflect how you will actually
do. You might start investing sooner or later. You might invest $300 each
year in your first two years, $3,000 per year in later years, and more as
you're able to. You might earn an average return of 10% over many decades,
or perhaps your return will be 7% or 15%. You can't control every
variable, but to a great degree, you can control how much you invest, how
you invest, and how long you let your money grow.
One of the most important factors 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.
(And in fact, you shouldn't begin investing until you've got more
knowledge under your belt.) 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 also that you can still enjoy your life while you're saving and
investing. You can amass great wealth by regularly investing a portion of
your income -- not all of it.
You Can Do It!
If you ever begin to doubt whether all this investing stuff is for you,
remember these things:You need a brain to do this -- and you have a brain.
You need time to do this, and you have time, too. (Teens have way more
time than most people.)
You won't have to sacrifice fun.
You won't have to save and invest every penny.
You won't have to spend hours and hours on investing every day, week or
month.
You can take a small amount of money and make it a bigger amount in just a
few years.
Try experimenting with compounding. You can do it the old-fashioned way,
with paper and pencil, or the less old-fashioned way, with a calculator.
Or fire up the Fool's snazzy online calculators (use the Retirement/Saving
one). You just plug in some numbers and it'll show you how much money
you'll end up with. Try changing the numbers you enter and see what
happens.
Happy compounding!
This article was adapted from The Motley Fool Investment Guide for Teens:
8 Steps to Having More Money Than Your Parents Ever Dreamed Of. For more
information on how compounding works and some additional amazing charts,
check out the book.
If you have some questions about anything you've read here, you can ask
them on our Teens and Their Money discussion board.
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