Compounding: Time and Discipline
11/08/2016 9:00 am EST
Some investors assume building wealth is about having an edge. They believe they need to get a hold of some key piece of information before anyone else does in order to get ahead, explains fund expert Janet Brown, editor of NoLoad FundX.
But experienced investors know that there are no shortcuts. Building wealth takes both time and discipline.
In fact, three of the most powerful and proven ways to grow your portfolio are actually very simple: (1) start investing as early as possible; (2) add to your investments regularly (even in small increments), and (3) stay invested to let compounding grow your portfolio over time.
One of the biggest assets you have as an investor is time. Over the long run, the stock market has had good gains, and if you’ve got time and the discipline to stay invested you’ll see those gains compound.
Compounding means that as your portfolio grows, you get interest and gains not only on your principle, but you also earn interest and gains on those interest and gains.
If you invest $25,000 and you gain 10% the first year, you’ll have $2,500 more in your account the second year. So if your portfolio grows another 10% the next year, your account will grow $2,750 in year two.
Even though your portfolio had the same percentage gain in these two years, your account earned an extra $250 because you had more money to start the second year. Over many decades, this can add up to millions of dollars.
Compounding is a huge benefit and the reason why if you start investing for retirement early, say at 25, you’re apt to have more money at age 65 than someone who started investing at age 35—even if the 35 year old is investing more money each year than you were at age 25.
One simple way to grow your portfolio faster is to add money to your investment account over time. It’s common sense that if you deposit more into your account, you’ll have more in your portfolio, but contributions can make a much larger difference than you may realize.
Say you invested $25,000 in the Vanguard 500 Fund (VFINX) in 1986. If you did nothing but hold on to that investment for 30 years, it would have grown to $444,527 by 2016.
But you could have built on these gains dramatically if you’d consistently added money to your account over these 30 years. If you’d put in as little as $250 every month, you would have contributed another $90,000 to your portfolio over the years.
But because you invested these contributions and your gains compounded, your overall portfolio grew to $866,184—almost double what you’d have if you’d only invested your initial $25,000! That difference could give you a completely different quality of life in retirement.
If you decided that instead of investing that $250 a month in the S&P 500, you’d put that money in a money market account that earned 1 to 3% a year, you still would have put aside an additional $90,000, but your contributions would have only grown to $132,704 over these 30 years.
This money would have been more stable — it grew over time and wasn’t affected by stock market declines — but the trade-off was that you missed out on substantial gains.
Adding your investment portfolio and your money market account together, you’d have accumulated $577,231 over this 30-year period—that’s nearly $300,0000 less than if you’d invested that $250 in the stock market each month.
This example is based on a relatively modest $250 addition to your account. If you were able to contribute $500 or even $750 each month, your portfolio would have grown even more dramatically.