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The Compounding Effect of Investing

The compounding effect of investing your money is perhaps one of the most important aspects to achieving long-term wealth.  For it to work, you must be a long-term investor with a lot of patience.  Here is a summary of how it works.

Say that you invest $1,000 and that you achieve a return of 10% per year.  That means that in the first year you would have $100 in gains ($1,000 x 10%) and a total of $1,100.  In the second year, you'll start with $1,100 but this year you'll earn $110 ($1,100 x 10%) for a total of $1,210.  The third year you will earn $121 ($1,210 x 10%) and have a total of $1,331.  You'll notice that each year you earn significantly more than the year before because each year you earn money on the previous years' gains.  This is called the compounding effect of money and it is one of the most important aspects to investing and saving money.

It is important to understand that the longer you keep your investment, the more money you will make.  However, the amount of money you make does not rise in a linear fashion.  Instead, for each year you keep the money invested, you will earn significantly more money.  This can be illustrated in the following manner:

If you earn 10% per year, at first glance, it seems like it will take you 10 years to double your money (10 x 10%)), and 20 years to triple your money (20 x 10%).  However, this couldn't be further from the truth.  If you keep compounding your gains and earning 10%, you will actually double your money in under 8 years, and triple your money in under 12 years.  Your money will quadruple in 15 years and you will have over 6 times your investment by year 19!

To illustrate this effect, we've added a graph and table below that shows the effect of compounding your investments:

Total Dollars by Year, Assuming a 10% Annual Return

 

Total Dollars Invested and Profit Per Year, Assuming $1,000 Initial Investment and a 10% Annual Return

Year Total $ Profit $   Year Total $ Profit $
0 $1,000 $100   21 $7,400 $740
1 $1,100 $110   22 $8,140 $814
2 $1,210 $121   23 $8,954 $895
3 $1,331 $133   24 $9,850 $985
4 $1,464 $146   25 $10,835 $1,083
5 $1,611 $161   26 $11,918 $1,192
6 $1,772 $177   27 $13,110 $1,311
7 $1,949 $195   28 $14,421 $1,442
8 $2,144 $214   29 $15,863 $1,586
9 $2,358 $236   30 $17,449 $1,745
10 $2,594 $259   31 $19,194 $1,919
11 $2,853 $285   32 $21,114 $2,111
12 $3,138 $314   33 $23,225 $2,323
13 $3,452 $345   34 $25,548 $2,555
14 $3,797 $380   35 $28,102 $2,810
15 $4,177 $418   36 $30,913 $3,091
16 $4,595 $459   37 $34,004 $3,400
17 $5,054 $505   38 $37,404 $3,740
18 $5,560 $556   39 $41,145 $4,114
19 $6,116 $612   40 $45,259 $4,526
20 $6,727 $673        

 

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