Sunday, March 25, 2007

Compounding - Thinking BIG

It seems to me the time value of money and the impact of compound rates of return are some of the most misunderstood elements of investing. We seem to have a tendency to conceptualize growth in a linear fashion and to underestimate the longer-term implications of compound or geometric growth.

Many of us are probably familiar with the rule of thumb that an investment earning 10% annually will double in value in about 7.3 years. The table below lists other combinations of rates of returns and how many years it takes an investment to grow to a specific size.

What I find interesting is the far right of the table - and what the power of compounding can do for us if we start early enough in life, make smart decisions, and let the power of compounding work for us. For example, at a 10% annual rate of return it will take 48.3 years for an initial investment to increase to 100 times the initial investment. (Yes an initial investment of $10,000 at age 20 will become over $1,000,000 by the age of 69 at a consistent 10% annual return.)

Think BIG: Within our lifetimes we clearly have the ability to drastically change our circumstances and security with a focused investment approach, and it helps if we think not in terms of turning $10,000 into $20,000 in the first 7.3 years (2X), but instead of how the same math turns that $10,000 into $1,000,000 in 48.3 years (100X).

Now, I've shown rates of return in excess of 10% (roughly the long term rate for the S&P) because I think the Average Joe investor can beat the market averages, but we'll have to continue this discussion in an upcoming post.

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