The Miracle of Compounding

12/10/2013 9:00 am EST

Focus: STOCKS

According to legend, Albert Einstein extolled the virtues of compound interest, purportedly calling it from "the eighth wonder of the world" and "more complicated than relativity theory", suggests Natasha Gural, contributor to Better Investing Magazine.

With some initial principal and a lot of time to build, compound interest can help grow your investments significantly over time.

Monthly or quarterly periods of compounding could exponentially generate a wealth of total returns, because you're earning money from the interest you've already earned. Reinvesting dividends can also create many of the same benefits that compounding interest offers.

When you reinvest dividends and buy more shares with dividends earned, you'll earn more in the long-term than if you were to just cash-out dividend income.

If you invest $10,000 in a dividend stock with an average annual return of 12% (stock price appreciation plus dividend yield) and you reinvest the dividends, that investment would be worth $299,599.22 in 30 years.

Investing $10,000 in a non-dividend-paying stock, with the same annual return over the same amount of time, would leave you with $138,000 over the same period of time.

The longer money compounds, the faster it grows. Investments increasing at 6% per year will double in about 12 years, and will grow four-fold in 24 years.

The Rule of 72 is the easiest way to figure out how long it will take for your investment to double, taking compounding into consideration. If you expect your investment portfolio to return 6%, your funds will double in 12 years (72 divided by 6).

The rate of return you earn from investing is as important as the amount you invest. A few percentage points in investment returns or interest rates can make a major difference in your future wealth.

Although stocks may be a riskier investment than other low-cost and accessible investment vehicles in the short-term, the rewards of stock investing can outweigh the risks in the long-term.

To benefit from compound interest, you should start investing early, invest as much as possible, and attempt to earn a reasonable rate of return.

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