A>T THE HEART of sound investment theory is a simple calculus known as the Power of Compounding. We know, it sounds like the punch line to a joke you might overhear at a CPA convention. But believe us, there's nothing nerdy about it.
What the bean counters know is this: If you put your money in an investment that delivers a return -- and then reinvest those earnings as you receive them -- the snowball effect can be astounding over the long term. This is particularly true in retirement accounts, where principal is allowed to grow for years tax-deferred or even tax-free.
Suppose you have $10,000 in your bank account and decide to put it into an investment with an 8% annual return. Over the space of the first year, you earn $800 on your investment, giving you a total of $10,800. If you leave those earnings alone, rather than pull them out to spend, the second year would deliver another $864, or 8% on both the original $10,000 and the $800 gain. Your two-year total: $11,664 and climbing.
Compounding produces modest -- if steady -- gains over the first few years. But the longer you leave your money in, the faster it grows. By year 20 in our example, your money would've quadrupled to more than $46,000. If you'd invested $20,000, it would've soared to more than $93,000.
Of course, the power of compounding also works for cash accounts such as money-market funds. But if you adjust the interest rate downward to 4%, you give up a lot: Your 20-year return on that $10,000 drops to around $22,000. Now dial the interest rate up to 13%, the average historical return of large-cap stocks. At that rate, your $10,000 investment balloons to a rich $115,231.
The lesson is this: The longer you leave your money invested and the higher the interest rate, the faster it will grow. That's why stocks are the best long-term investment value. Of course, the stock market is also much more volatile than a savings account. But given enough time, the risk of losses is mitigated by the general upward momentum of the economy. We'll show you why in the next lecture.