ompounding is earning "interest on interest," where your original savings generates a return that creates more money. Staying invested and contributing regularly can significantly increase your assets over time as your savings grow and the effect accelerates—a powerful force in a long-term savings strategy.
Stuart Ritter, CFP®, a senior financial planner with T. Rowe Price, explains the concept this way: "Imagine you have a barren field—and one day sow some plants. Each of them will generate seeds that then grow into new plants, which will also start generating seeds. Over time, assuming a positive rate of growth, your field will become more rapidly covered in plants from the new seeds instead of from your original planting."
STARTING TO SAVE NOW
The sooner you begin to invest, the more you can benefit from compounding. Even if you start with small contributions, your savings will begin to potentially generate returns that will seed your nest egg. Waiting could have consequences—if unexpected events, such as a medical emergency or an unplanned period of unemployment, force you to interrupt or reduce your savings plan, you'll have to increase your contributions to an even higher rate. "The longer you wait to start," Ritter says, "the more money you will have to save once you begin in order to achieve to the same goal."
STARTING SMALL—GROWING BIG
Consistently saving over time can add up to a significant nest egg.
A young adult who will retire in 40 years makes an initial contribution of $1,000 into a Roth IRA and adds $100 a month. After four decades of saving, she had more than $250,000—all tax-free.
Assumes a hypothetical average annual return of 7%. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.
As an investor, your ultimate goal is to grow your balance to the extent needed to reach your objectives. One path to increasing value is to implement an automatic investing strategy, whereby you invest at regularly scheduled intervals. Automatic investing helps to prevent lapses in your investment plan due to events such as short-term market developments or personal circumstances. Of course, automatic investing cannot assure a profit. Since such a plan involves continuous investment regardless of fluctuating price levels, investors should consider their financial ability to continue purchases through periods of both high and low price levels.
PASSING ON YOUR INVESTING KNOWLEDGE
One important step you can take is to talk to your children about money early in their lives. Impress upon them how valuable and advantageous it is to start investing while they're young. They'll be more likely to reach their most important financial goal—having enough saved for a comfortable retirement many decades in their future. A Roth IRA may be the best savings vehicle to help them because qualified withdrawals after a lifetime of saving and investing will be tax-free. Says Ritter, "Getting a young person started with just $100 from each paycheck will provide a significant jump-start on potential compounded savings growth."