INTELLIGENT INVESTING:

The Power of Compounding Interest

Compounding interest is the foundation for successful investing and has been referred to by Albert Einstein as "the most powerful force in the universe."  In this simple mathematical concept, the growth of an investment's value is calculated on the sum of the original investment plus the assumption that dividends or interest are re-invested in that same asset.  In other words, compounding interest is a process in which interest is earned on interest.  

Examples of compounding are typically quite enlightening to both novice and experienced investors alike, so let's look at a scenario.  Mr. Early and Mr. Late are two individuals who achieve an amazingly consistent 10% annual return on a mutual fund investment over a 40-year period.  

Mr. Early got some intelligent investing advice from a friend and immediately began investing $2000 per year during years 1-8, for a total investment of $16,000.

In contrast, Mr. Late did nothing for years 1-8 but then realized he needed to start investing.  He then proceeded to invest $2000 per year during the 32 year period of years 9-40, for a total investment of $64,000. 

Source: S&P's The Outlook

	1		$2,000		$2,200		$0		$0
	2		2,000		4,620		0		0
	3		2,000		7,282		0		0
	4		2,000		10,210		0		0
	5		2,000		13,431		0		0
	6		2,000		16,974		0		0
	7		2,000		20,871		0		0
	8		2,000		25,158		0		0
	9		0		27,674		2,000		2,200
	10		0		30,441		2,000		4,620
	11		0		33,485		2,000		7,282
	12		0		36,834		2,000		10,210
	13		0		40,517		2,000		13,431
	14		0		44,569		2,000		16,974
	15		0		49,026		2,000		20,871
	16		0		53,929		2,000		25,158
	17		0		59,322		2,000		29,874
	18		0		65,254		2,000		35,061
	19		0		71,779		2,000		40,767
	20		0		78,957		2,000		47,044
	21		0		86,853		2,000		53,948
	22		0		95,583		2,000		61,643
	23		0		105,092		2,000		69,897
	24		0		115,601		2,000		79,087
	25		0		127,161		2,000		89,196
	26		0		139,877		2,000		100,316
	27		0		153,865		2,000		112,548
	28		0		169,252		2,000		126,003
	29		0		186,177		2,000		140,803
	30		0		204,795		2,000		157,083
	31		0		225,275		2,000		174,991
	32		0		247,803		2,000		194,690
	33		0		272,583		2,000		216,359
	34		0		299,841		2,000		240,195
	35		0		329,825		2,000		266,415
	36		0		362,808		2,000		295,257
	37		0		399,089		2,000		326,983
	38		0		438,998		2,000		361,881
	39		0		482,898		2,000		400,269
	40		0		531,188		2,000		442,496
	Investment				$16,000				$64,000
	Earnings				$515,188				$378,496

At the end of the 40 year period, Mr. Late has invested four times as much money as Mr. Early, yet his total earnings are $136,692 less.  

The resulting values of each investment is a dramatic example of the two most powerful allies of the successful investor -- time and the power of compounding interest.  

Focus on a Long-Term Plan

Almost without exception, financial resources recommend the development of a long-term investing plan because of the stock market's historical performance.  In the 69 years between 1928 and 1997, the Standard and Poors 500, the largest companies in the U.S., has yielded an average annual return of 10.19%.  This statistic best exemplifies why you should "get in and stay in" the market, and also shows that having the fortitude to ride out market downturns is rewarded in the long run. 

In contrast to the measured, long-term perspective of investing is a process known as trading.  Trading involves investing based on short-term market fluctuations and depends on "buying low" and "selling high" for successful returns.  If you can consistently time the market in this manner, you should probably be working on Wall Street instead of attending dental school here at UB.  

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Last modified: August 16, 1999