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  • By Judith Ward on March 19, 2012

    What Is Compounding?

    Compounding—or earning 'interest on interest'—can help accelerate the growth of your assets over time. For simplicity's sake, let's say you invest $1,000 at a 10% annual rate of return. After one year, your investment would have earned $100 and be worth $1,100.

    Over the next year, you would earn 10% not only on your original $1,000 investment, but on the $100 in earnings as well, or $110. The added $10 acts as a kind of bonus—a way to make more money out of your investment, even if you don't put in any additional principal.

    Compounding Over Time

    The effects of compounding are modest at first, but, over time, they can dramatically accelerate your accumulation of wealth. The following chart, which displays the growth of a $5,000 investment earning 7% annually over 10, 20, 30, 40, and 50 years, shows how valuable this acceleration can be.

    The Growth of $5000

    Every year you wait to invest reduces the potential benefit of compounding. Taking the above example again, the original $5,000 invested would have grown to $5,725 after two years. If you wait two years to invest the same $5,000, you've lost two years of growth that, over time, could compound to many thousands of dollars. For this reason, whatever your investment goals, the earlier you invest the better.

    Rule of 72

    How much can compounding affect your portfolio? You can use a math trick called the Rule of 72 to estimate the impact. For any investment, consider the likely long-term rate of return (or the percentage that your investment is likely to earn annually). Divide that number into 72, and your result is the number of years that it would take you to double your money. For example, if you estimate 7% as your likely rate of return, it would take a little over 10 years to double your money. It's not exact, but it will give you a rough idea.

    More Investing, More Compounding

    You can ramp up the effects of compounding by adding regularly to your investments. By adding to your original principal, compounding goes to work on your original principal, your subsequent investment, and your earnings on both. The "Compound and Compare" chart shows how an account can grow depending on the amount you contribute annually and the length of time you invest.

    Your Savings at Age 65

    The Role of Compounding in Your Investment Strategy

    Compounding is a critical component of your investments' long-term value, and you can take advantage of it at any time, simply by investing as soon as you can. The earnings acceleration that compounding provides can:

    • Improve your chances of reaching your investment goals.
    • Enhance the return on your investments in order to reach your goals.
    • Help you fight the eroding effects of inflation on your investments.

    If your portfolio is heavily invested in bonds, dividend-paying stocks, or other income-generating investments, you can take advantage of compounding as well. Reinvesting any dividends and interest payments, instead of taking them in cash, can have a profound effect on your earnings.

    Make Compounding Work for You

    The earlier and the more regularly you invest, the more compounding can become a powerful ally in helping you reach your goals. Compounding can be particularly beneficial in accounts such as a 401(k), an IRA, or college savings. But even if you're already in retirement and taking payments from your retirement accounts, reinvesting earnings can potentially help make your money last longer and keep it growing.

    You work hard for the money you invest, and you've got big plans for it—college expenses, retirement, starting your own business, traveling the world. Make your money work harder by taking advantage of the power of compounding.

    T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.