If you lived through the 1970s, you probably know the visceral fear that accompanies the word “inflation.”
During that “Great Inflation” period, the rate of price increases surged to double-digit levels—reaching 14% by 1980. Businesses were destroyed; household budgets were shredded. Only by raising interest rates to a painful 20% did the Federal Reserve manage to finally break inflation’s back.
Inflation remains a force to be feared: Even in this era of very low-inflation, it’s a staple topic for pundits and the financial media. While there are occasionally periods of dramatically spiking inflation, the phenomenon’s real power lies in its long-term, snowballing effect.
In 1970, the average new home cost just over $23,000. By 2013, it cost nearly $300,000. A loaf of bread cost 25 cents then; now it costs about $2. If our income doesn’t rise to match the cumulative power of inflation, we’re in trouble.
But the long-term, snowballing effect can also be turned in our favor, by harnessing the power of compound investment returns. Like inflation, the effect of compounding is hard to perceive over short periods of time. Over the long haul, though, it can have an enormous impact on our investing success.
Compound returns are generated by continually re-investing our earnings in order to generate earnings of their own. Compounding takes the money we’ve earned and makes more money out of it—and then it makes more money out of that money, ad infinitum.
Here’s a simplified hypothetical example to illustrate the power of compounding. Suppose you have two investment accounts, each with $100,000, each earning a steady 6% a year. In account A, you withdraw your earnings each year. That account, of course, stays flat at $100,000, year after year.
In account B, you reinvest your earnings. After a year, your account contains $106,000—a nice gain, but not an earth-shattering one. After five years, your capital has grown to $130,382. After 10 years, your money approaches $180,000, and the power of compounding is becoming hard to miss. The growth is coming faster now; in 15 years you’re nearly at $240,000. After 20, you’ve got more than $320,000. In 30 years, you’ve surpassed $570,000.
At that steady 6% return, account A is still generating $6000 per year, even after 30 years. Account B, meanwhile, increases its growth rate every year; by year 30 it generates $32,510 in new money. No wonder Albert Einstein dubbed compounding “the eighth wonder of the world.”
There’s a strong case to be made for an investment strategy powered by compounding your returns, and we’ll write more about the topic in the weeks and months to come. If you would like help harnessing the power of compounding the returns of your investments, we may be able to help. That’s just part of what we do.
