Do you want to learn what compounding returns mean? It’s a term often used when people talk about personal finance and money. Let’s go into what compounding means and how it can make you rich!
People often throw around terms like it’s nobody’s business, personal financial NOT being an exception.
Compounding is a term often used when people talk about money. They will just assume you know what it means and continue the conversation.
I mean, it’s not like we learned anything about money management in school. If economics was supposed to teach us that, they didn’t do such a great job imo.
What Does Compounding Mean?
Compounding happens when you take a number and increase it by a percentage, instead of by a fixed amount. Compounding means that a percentage increase will lead to a bigger increase on the long term. This can also be referred to as exponential growth.
An Example Of Compounding
For example, say you are writing on your blog and you write 1000 words per week. You want to write more and get in the habit of writing. You want to write 10% more every month.
10% of 1000 words is 100 more words weekly, right? Here is how you would think that would look:
Week 0, your starting point: 1000 📓
Week 1: 1000 + 100 = 1100 📓
Week 2: 1000 + 100 + 100 = 1200 📓
Week 3: 1000 + 100 + 100 + 100 = 1300 📓
Week 4: 1000 + 100 + 100 + 100 + 100 = 1400 📓
Week 5: 1000 + 100 + 100 + 100 + 100 + 100 = 1500 📓
Week 6: 1000 + 100 + 100 + 100 + 100 + 100 + 100 = 1600 📓
After 6 weeks, you have 600 extra words written.
While that’s great, that’s not exactly how compounding works. You don’t write just 10% of your beginning words extra every month. You get an additional 10% based on the words of the previous week.
That looks something like this:
Week 0, your starting point: 1000 📓
Week 1: 1000 + (1000 * 10%) = 1100 📓
Week 2: 1000 + (1100 * 10%) = 1210 📓
Week 3: 1000 + (1210 * 10%) = 1331 📓
Week 4: 1000 + (1331 * 10%) = 1464 📓
Week 5: 1000 + (1464 * 10%) = 1611 📓
Week 6: 1000 + (1611 * 10%) = 1772 📓
After 6 weeks, you have 772 extra words written.
When you compound the number every week, you end up with more words written. That’s the magic of compounding.
Another example of compounding is this question: do you want a penny doubled for 30 days or $1 million today?
What Does Compounding Have To Do With Money?
There are two main ways your money can compound:
- Compounding interest
- Compounding returns
Let’s go into them both!
What Is Compound Interest?
With Compound interest, you earn interest on money that was previously earned as interest. For example, your bank account pays 0.5% interest on your savings account, your money will increase by 0.5% year over year.
If you’re borrowing money from someone else, you can imagine that compounding can very much work against you. You pay interest on the money you have borrowed, meaning that the amount you need to pay goes up if you don’t pay off your balances. For example, you have some credit card debt against 15% interest, the amount you need to pay back increases with 15% yearly.
What Are Compound Returns?
Compound returns usually mean the return you get when you’re investing. Where interest is a fixed amount, investing returns are variable. While some years can be up 20% and some years down 10%, the market pays an average of 7% return.
When you’re investing in the stock market, the underlying value of the companies you’re investing in goes up, which in turn increases your investment balances. As long as you keep investing, your returns can compound.
Investing in the stock market has big benefits, but it also carries risks. The stock markets can return negative returns over a couple of years or even over a decade.
In general, the markets go up 75% of the time. That means your money is compounded over time. The more time goes by, the more your money will be worth.
Do you want to maximize return? See what’s the best to invest in Large Cap, Mid Cap, or Small Cap stocks.
How To Get Rich With Compounding?
Here are a couple of ways that you can benefit from compounding:
1. Start Early
When you’re growing your savings or investments, time is on your side. The longer you manage to not touch the money, the more it will grow. When compounding, your money starts to grow exponentially over time.
For example, you start investing at 25 and you invest $1000 yearly at a 7% annual return, you will have $215,000 when you’re 65. Of this $215,000, only $41,000 is your initial money – that means you’ve earned $174,000 with compounding.
If you start investing at 35 and invest $1000 yearly at a 7% annual return, you will have $102,000 when you turn 65. Of this $102,000, $31,000 is your initial money – which means you’ve earned $71,000 with compounding. That’s over $100,000 less money earned, just because of 10 years.
If you start investing at 40 and double your initial amount to $2,000 yearly at a 7% annual return, you will have $137,000 when you are 65. Of this, $52,000 is your own money and you’ve earned $85,000 with compounding returns.
To illustrate, if you start investing at 40 and you want to have the same amount at 65 as someone who started at 25, you need to bring in over $3,000 per year. That’s 3 times more!
While it’s not impossible, you’re doing yourself a disservice to wait to start investing. Investing is one of the best things you can do. If you don’t know anything about investing, simply start with a low-cost index fund and go from there.
2. Starting Small is Great
Many people that I talk to, tell me that they can’t start investing because they don’t have much money left over at the end of the month.
That’s totally fine! You don’t need a lot of money to start investing!
You would rather start with $25 per month, than not start at all. Make sure you set up an auto-transfer to your brokerage account and you contribute monthly.
Just doing this can make you a millionaire when you reach retirement age.
Looking for brokers? My favorites are:
- Vanguard – US-based company that lets you buy index funds for cheap
- DEGIRO– A low-cost European broker that I’m personally using
- M1Finance – A US robo-advisor/broker with no trading fees, no account fees, and you can start investing with any amount!
3. Don’t Try To Time The Market
Time in the market is more important than timing the market. While many people may think they know what the stock market is going to do, no one actually knows.
Leave your money in the market and give it time to grow. If you let your money compound now, you’ll be much more likely to retire with sufficient funds and achieve any money goals that you may have.
4. Keep At It Consistently
Stick to this over the long term. Keep investing and keep contributing – the longer you keep at it the more you will see the compound effect over time.
It does take some time to notice the compound effect – so don’t give up too early!
Get Rich With Compounding Returns – All In All
With compounding returns, you will get a return on your return. This results in your returns growing exponentially over time.
When you’re investing early, your investments will have more time to grow and thus you will have a more compounding effect. Don’t be afraid to start small, over time all those $20 that you invested will add up and be $300!
Instead of trying to time the market, try to invest regularly. You never know when the ups and downs are coming. Besides, historically speaking, there have been more up than down years.
Keep at it consistently over time and you will grow your wealth beyond your wildest dreams!
How are you using compounding returns to get rich?
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