THE POWER OF COMPOUNDING

The earlier you start saving for retirement, the less money it will take as a percentage of your income to achieve your goal. The opposite is also true, unfortunately. The less time you have, the higher percentage of your income you’ll need to contribute to achieve your goal.

This is due to the power of compound interest. The important lesson of compounding is that you should start saving and contributing to your 401(k) as early as possible. There exists an incredible window of opportunity for maximizing the power of 401(k) plans from your early twenties until your late thirties.

Every investor needs to fully understand compounding and how to benefit from its amazing power. This is another one of those things that everyone should learn in high school.

This graph below shows the balance of a 401K where the individual started contributing at age 25 and contributed an equal amount each year. The annual investment return rate or growth rate is also constant. So, the only factor affecting the slope of the line is compounding. Notice how the line start curving straight up after age 50. This is the compound effect.

A 401K investor can affect their retirement account balance the most by starting to make contributions as early as possible – in their 20s or 30s – and by generating higher investment returns through their fund choices. Compounding multiplies the impact of earlier contributions and higher investment returns. This is not the case when you increase the amount that you contribute to your 401K.

I have quantified the comparison of time length, investment returns, and 401K contributions illustrate this point.

Everything else being equal:

• A 33% increase in number of years contributed leads to a 103% increase in the account balance at age 65.

• A 33% increase in investment returns leads to a 78% increase in the account balance at age 65.

• A 33% increase in employee contributions leads to a 33% increase in the account balance at age 65.

Start early and maximize your investment returns to ensure that you have enough money to retire at age 65.

Happy Investing,

Phil

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