Compounding is a simple investment strategy in which you put your money in an investment that pays a return.
We've seen compounding referred to as "the most powerful force in the universe," "the royal road to riches" and "the greatest mathematical discovery in human history."
Albert Einstein called compounding the eighth wonder of the world.
Compounding is a simple investment strategy in which you put your money in an investment that pays a return. At the end of the year, you take your return and reinvest it with your original stake. Your dividend, or interest, earns a return, too, building a bigger dividend - or higher interest payments - the next year.
A snowball is the best analogy for compounding. As you roll the ball through the snow, the surface area gets bigger. The more surface area on the snowball, the more snow it picks up. The snowball gains mass slowly at first... but pretty soon, it's so large you can't move it.
Compounding is slow and boring at first. But gradually, the dividends grow, and your reinvestments increase. One day, you wake up to find your account producing thousands of dollars per year in dividends and your wealth a giant snowball.
Here's a mind-blowing example from a study conducted by Richard Russell of the Dow Theory Letters on the power of compounding:
An 18-year-old girl puts $2,000 into an account each year from the ages of 19-25, then stops contributing and lets it compound at a rate of 10% until age 65. That means she has contributed only $14,000 in total. But because of compounding, by age 65, she's almost a millionaire, with $944,641 in her account.
Now, let's say this girl has a twin brother. He's not as disciplined and continues to blow his money on useless things. Finally, at age 26, he realizes he needs to start saving, too.
He puts $2,000 per year into his account starting at age 26. He also lets his money compound at a rate of 10% until age 65. Except he contributes $2,000 every single year from ages 26-65. That means he's contributed $80,000 in total... more than five times what his sister has contributed. By age 65, he's almost a millionaire, too, with $973,074 in his account.
Who's the winner?
The sister contributed only $14,000 (2,000 per year over seven years) and ended up with $944,641. That's a net gain of $930,641, or 66 times her original investment.
The brother contributed $80,000 ($2,000 per year over 40 years) and ended up with $973,074. That's a net gain of $893,704, or 11 times his original investment.
The sister was able to accomplish much better results with much less money... all because she realized the power of compounding money over long periods of time. If you missed this, go back and read the example again until you realize what happened.
Not only is compounding an incredible wealth builder, but it's also simple to do. First, you need an investment that generates a return every year for many years in a row. Then, you need time and perseverance to let the dividends grow.
Compounding doesn't require vigilance, activity, or effort to make it work. In fact, it works best when you forget about it altogether.