Here's another interesting post from our partners at InvestingAnswers:
Grace Groner lived nearly her entire life in Lake Forest, Illinois, about 45 minutes north of Chicago.
After graduating from Lake Forest College in 1931, Grace was hired as a secretary at Abbott Laboratories, where she worked for more than four decades.
Grace never earned an amazing salary as a secretary. According to theLos Angeles Times, she got her clothes from garage sales. She lived in a one-bedroom house that was willed to her when a friend passed.
But in 1935, a few years after she started her job at Abbott Labs, she bought three shares of the company's stock for about $60 per share. Her total investment was under $200.
Grace never sold those shares. Through dividends, share splits, and dividend reinvestment, when she died in 2010, her three share purchase was worth $7 million. She left it all to her alma mater.
The two most important lessons from this story?
A) She started with $200.
B) She took advantage of the power of compounding -- for 75 years!
Compounding is often referred to as "magic" because it is one of the most fundamental ways to build wealth, yet takes the least amount of effort.
Compounding is simply earning interest on interest or dividends on dividends.
Compounding On An Investment Left Alone
Ms. Groner's shares grew at healthy average of 14.97% per year over the 75-year period. It's hard to get those kind of returns with every investment, so we'll be fairly conservative with our example's estimates.
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Let's assume you buy seven shares of a relatively stable, dividend-paying stock, such as AT&T. At $29 per share, purchasing seven shares would mean you invested $203 total into the stock, with a dividend yield that would pay you around 6% annually.
By the end of the first year (assuming AT&T's performance remained stable), AT&T would have paid you around $12 worth of dividend checks (think of these like interest from a bank account). Instead of cashing the dividend checks, you decide to reinvest the $12 back into your investment. Now you have $215 invested in AT&T ($203 + $12 = $215).
If you leave the $215 invested in the stock for Year 2, you'll receive $12.90 in dividend checks by the end of that year -- $0.90 more than Year 1. If you reinvested that $12.90 back into the stock, your total invested dollar amount grows to $227.90.
Leave your $227.90 alone for Year 3 and by the end of the year your investment would earn $13.67 -- and on and on your reinvested earnings would grow and grow.
If you followed the strategy of reinvesting your dividends every year for another eight years, here's how your original $203 investment would grow:
By leaving your money and letting its returns compound, you're allowing your dollars to earn interest off of its own interest -- all without having to lift a finger. Thanks to compounding over 10 years, your original $203 investment yielded $160 worth of earnings.
While $160 in earnings over 10 years doesn't seem like much, imagine the effect of compounding with much larger balances, much longer periods of time and much faster growth rates.
The Power Of Compounding With A Monthly Investment Plan
Let's say you're able to invest $100 every month.
Although that might not seem like a tremendous amount of money, a $1,200 annual investment for 30 years at just 6% a year can make your money grow to over $100,000.
That means by investing $36,000 ($1,200 times 30) instead of spending it, you would earn an extra $64,000 -- without putting in extra hours at the office.
Still not convinced compounding is powerful?
If you invested $400 a month, every month, in an investment that gave you a 6% return, your investment dollars would grow to nearly $800,000.
The Caveat To The Magic Of Compounding
It looks easy -- and it is. But there is one minor detail that often trips folks up.
The miracle of compounding takes a while to build up a head of steam. The first few years can be boring. As you saw in our dividend-paying stock example above, compounding only earned us an extra $160 after 10 whole years.
However, time is the most important element when it comes to compounding. The earlier you start investing, the more years your investment dollars can compound, and the larger your investment will grow.
The Investing Answer:
So I'm going to let you in on a little secret. Because I work in finance, I've run hundreds, maybe thousands of financial models. That usually means setting up a spreadsheet to forecast investing results far into the future. Even after all the examples I've seen of the power of compounding, it never fails to amaze me.
I'm a numbers person so that's how I know to trust in compounding. But if you're a "words" person, maybe this will help with the concept:
"The best time to plant a tree was 20 years ago. The second-best time is today."
This investing "loophole" is very powerful. In my mind, it means that no matter where you are in life -- and no matter what mistakes you've made in the past -- now is the time to change your future. Start planting your orchard. It only takes however many seeds you have in your hand right now, whether it's 100 or one million. You're in control of your financial destiny.