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Let the Compounding Effect Work for You

Coin Bar

"Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." — Albert Einstein

"Someone is sitting in the shade today because someone planted a tree a long time ago." — Warren Buffett


There is an ancient story, which explains the power of compounding if one starts to save and invest early, regularly, and sticks to it for a long period of time. It centers around the invention of the game of chess which was recounted the Sahnameh, an epic poem written by the Persian poet Ferdowsi between 977 and 1010. Here is how it is translated in this Wikipedia article.

"When the creator of the game of chess (in some tellings an ancient Indian Brahmin mathematician named Sessa or Sissa) showed his invention to the ruler of the country, the ruler was so pleased that he gave the inventor the right to name his prize for the invention. The man, who was very clever, asked the king this: that for the first square of the chess board, he would receive one grain of wheat (in some tellings, rice), two for the second one, four on the third one, and so forth, doubling the amount each time. The ruler, arithmetically unaware, quickly accepted the inventor's offer, even getting offended by his perceived notion that the inventor was asking for such a low price, and ordered the treasurer to count and hand over the wheat to the inventor. However, when the treasurer took more than a week to calculate the amount of wheat, the ruler asked him for a reason for his tardiness. The treasurer then gave him the result of the calculation, and explained that it would take more than all the assets of the kingdom to give the inventor the reward. The story ends with the inventor being beheaded. (In other variations of the story, the inventor becomes the new king.)"


(Source: Wikimedia Commons, Author: Andy0101)

Of course, the power of compound interest is most relevant these days when it comes to managing our personal finances. Let’s take a look at few scenarios to show how saving and investing early can positively affect your ending balances in retirement.

Scenario 1:

Jack decides to start saving for retirement at age 25. He takes advantage of the 401(k) plan at work and contributes $18,000 (the maximum for 2015) per year until age 45. He stops saving, and he just lets the interest work in his favor. At age 65, assuming a 10% annual rate of return he will retire with $7.3 million.

Jill waits to save and invest until she is 35. She starts contributing to her 401k at work the same $18,000 per year that Jack did but does until age 65. Her total amount contributed to her 401(k) account over those 30 years would be $540,000.00. At age 65, assuming a 10% annual rate of return she will retire with $3.1 million.

  Jack Jill
Annual 401k Contributions $18,000 $18,000
Annual Return 10% 10%
Years of Saving 20 30
Total Contributions $360,000 $540,000
Ending Balance $7,305,930 $3,118,939

If you notice, Jill has contributed about 1.5 times as much money as Jack did, but Jill ends up with almost $4.2 million less than Jack at retirement. This is due to compound interest and waiting to save and invest. Compound interest is interest added to the principal balance so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding.

Scenario 2:

Now let's assume that Jack doesn't stop saving at age 35 and continues to save the same amount year over year until he retires at age 65. Now he has over $8.3 million at retirement. His 10-year head start on Jill gave him more than double his ending balance. Again this is compound interest helping his cause. The more time you have to use it to your advantage the less work you have to do.

  Jack Jill
Annual 401k Contributions $18,000 $18,000
Annual Return 10% 10%
Years of Saving 40 30
Total Contributions $720,000 $540,000
Ending Balance $8,391,911 $3,118,939

Due to the power of compounding returns, an investment made early in life can generate a larger amount than a larger investment made later in life. Investing for a longer time is more effective than waiting until you have a large amount to invest.

Scenario 3:

Let's go one step further and see how the numbers would like if Jack invested in a well-diversified portfolio like IFA Index Portfolio 100 with glide path.

  Index Portfolio 100 with Glide Path
Annual 401k Contributions $18,000
Annualized Return 10.36%
Annualized Standard Deviation 13.07%
Total Return 5,057.64%
Years of Saving 40
Time Period 3/1/1969 to 2/28/2009
Total Contributions $720,000
Ending Balance $11,204,266

Note: Above numbers are the lowest rolling period returns for Index Portfolio 100 in 40 years in the last 50 years. The ending balance is heavily dependent on the sequence of returns.

Here are the detailed numbers from the IFA Index Calculator.

If you save, invest in a well-diversified portfolio, have the discipline and patience the power of compounding can do wonders to the investments made. If you have not started investing yet, you can start investing now and perhaps have a substantial amount for your retirement.

In our opinion, investing requires education, discipline and a fiduciary advisor. Our clients benefit from an unwavering commitment to strategies that incorporate financial innovations (or dimensions of expected returns) that are sensible, persistent through time, pervasive across markets and cost-effective to capture a well-diversified portfolio.

IFA's recommendation is that investors establish an investment policy by taking the Risk Capacity Survey and have a financial plan, then invest and relax.

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