You've heard the phrase "a penny saved is a penny earned." But what is a penny compounded? A whole lot more than you might think.
That's because of a powerful mathematical process called compounding, which Albert Einstein is said to have called "the most powerful force in the universe."
"Compound interest is the eighth wonder of the world," Einstein reportedly said. "He who understands it, earns it. He who doesn't, pays it."
Compound interest is the interest you earn on your money, plus the interest it's already accrued.
For example, if you deposit $100 in a savings account with a 5% interest rate, after one year, you'll have $105. If that interest compounds, in year two, you'll earn 5% on the $105, not just the initial deposit of $100.
So, after two years, your savings account would contain $110.25, and after three years, $115.76. With time and regular contributions, the compounding process can help you grow your wealth considerably.
To illustrate how powerful compounding can be, imagine that you're starting out with a single cent, and that it doubles every day. Thanks to that compounding, how much money would you have after a week or a month?
Let's start at the beginning. After two days, you'd have $0.02. After three days, you'd have $0.04, and so on. At the end of a week, seven days later, your single cent would have compounded into $0.64. And after a month, or 30 days, you'd have over $5,300,000. That's the power of compounding.
Video by Jason Armesto
To bring in a real-world example of the power of compounding, consider someone who starts saving $5,000 a year for retirement at age 25. By age 65, they could have twice as much money as someone who waits until age 35 to start stashing money away.
Experts say you should stick to a long-term strategy of saving and investing, partly because it allows the power of compounding to do much of the heavy lifting as you build wealth. "An average investor with a longer time horizon is going to have better results than an amazing investor with a shorter time horizon," Joshua Brown, CEO of investment advisory firm Ritholtz Wealth Management, recently told Grow.
Taking advantage of compounding is relatively easy: Start as early as possible, make regular contributions, and avoid tapping your account if you can avoid it. That will help you stay on track to meet your future goals.
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