Two of my boys are working this summer, one at the local hardware store and the other at the Snack Shack. (First jobs are exciting. Mine was milking cows at a small independent dairy. I learned a lot — especially what I don’t want to do when I grow up!) My boys are learning a lot and asking good questions about what to do with their paychecks. I’ve tried to teach them some best practices for investing, such as how to leverage the power of compounding to help you earn.
This is what I told them.
What Is Compounding?
In general, compounding refers to the process of something growing or accumulating over time, by successively building upon previous growth. Think of compounding like a snowball: It starts small, but as it rolls downhill, it becomes gigantic.
In finance and investments, compounding specifically refers to the ability of an asset, like an investment, to generate earnings or returns, which are then reinvested back into the asset to generate additional earnings. Compounding involves the returns earned not only on the initial investment, but also on those earned from previous periods. Putting this into practice can result in exponential growth over time.
After one year, the snowball is only a bit bigger. But after 10 or 20, look out!
How Compounding Works: An Example
Here’s a simplified example to illustrate how it works. (With compounding, the math can get hairy quickly. To illustrate more complicated examples, you can use a resource like an online compounding calculator
Suppose you invest $1,000 in a savings account with a 5% annual interest rate. You don’t touch the money at all, neither withdrawing your cash nor adding any more. However, with the 5% annual interest rate, your total will still grow, as it compounds annually.
At the end of the first year, you would earn $50 in interest ($1,000 × 5%), resulting in a total of $1,050.
At the end of the second year, the 5% interest is calculated based on the new total, so you would earn $52.50 ($1,050 × 5%). Your total amount then becomes $1,102.50.
Follow that through, and at the end of 10 years, you’re up to $1,628.89. At the end of 20 years? That $1,000 has become $2,653.30.
That’s the power of compounding.
Turning Money Into More
Even in my simplified example, you can see that the longer your investment period, the more pronounced the compounding effect becomes.
My sons could see it, too — which leads me to another key best practice about investing: If you really want your kids to listen to financial advice, ask them if they want to learn how to make their money snowball into more money. In my experience, you’ll get more engagement than you would by talking about something boring like compounding.
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