How compound interest works
Compound interest is the interest you earn on interest. You deposit an initial investment at a particular rate of return that could vary each year. A basic example would be if you invested $10,000 at an 8% rate of return.
- First year, you would have $10,000 x 1.08 = $10,800
- Second year, you would have $10,800 x 1.08 = $11,664
- Third year, you would have $11,664 x 1.08 = $12,597ᶦ
Compounding is a strategy that helps to accelerate the growth of your investment over time. This is not a fast-money-making scheme, as you will see. Compounding is often called “interest on interest”. To get the most out of compound interest, consider these steps.
Start early
The earlier you begin investing, the more beneficial compound interest will be. It begins working right away but takes decades to grow.
Choose a diverse variety of investment vehicles
Having a diverse collection of investments can help to hedge against inflation and reduce some of the risk of investing. Although you can never fully eliminate risk, investing is a time-tested strategy that could potentially help you grow your investments, while navigating the ups and downs of the market. For long-term investors intent on tapping into the potential power of compounding, they are not concerned with the day-to-day market volatility. Several types of investments include:
- Stocks – Stocks, also known as equities, are partial ownership in a company. You can buy full shares or fractional shares. Returns from stocks (profits from price appreciation or dividends) on your initial investment are reinvested. This creates a snowball effect over time in which compounding eventually accelerates, potentially growing your investment.
- Bonds – Bonds are a loan one gives to a creditor either a company or the government. That entity then agrees to pay a specific yield in return for the investor buying the debt.ᶦᶦ
- Mutual funds – An investment vehicle that pools money from many investors to purchase a collection of securities like stocks, bonds, or other assets.
- Savings accounts – A type of bank account designed for storing money that you don’t need for immediate spending. You may earn a low interest rate on your deposits.
- Certificates of Deposit (CDs) – CDs require a minimum deposit and pay you interest at regular intervals over a period of time, typically three months to five years though they can go much longer.
- High-yield savings accounts – A high-yield savings account is similar to a regular savings account except they have a higher interest rate. You typically accrue money while having your money safeguarded by FDIC insurance (up to $250,000 per account), just like a traditional savings account.ᶦᶦᶦ
- Exchange-traded funds (ETFs) – A type of investment fund that holds multiple underlying assets and can be bought and sold on a stock exchange like individual stocks. ETFs offer diversification and flexibility as an investment opportunity.
- Money market funds – A type of mutual fund that focuses on investing in highly liquid, short-term debt instruments.ᶦᵛ
- Real estate investment trust (REITs) – A company that owns, operates, or finances income-producing real estate. Structured after mutual funds, REITs work to provide investors with a consistent income stream, diversification, and long-term capital appreciation.ᵛ
- Index funds – A type of investment fund, either a mutual fund or an exchange-traded fund (ETF), that works to mirror the performance of a specific market index, like the S&P 500.ᵛᶦ
Reinvest the returns
Some people take their returns as cash, however, to benefit from compound interest consider reinvesting your returns. When you reinvest your returns, the money will automatically buy more stock. Over time this may allow for growth potential.
Consistency is key
Being consistent with the contributions to your investments, as well as being consistent in not falling into the habit of buying and selling due to fluctuations in the market, is key to the possibility of experiencing significant long-term growth. One helpful strategy is to dollar-cost average. This is when you take the same amount of money from each paycheck, or the same amount of money each week or month, and contribute it to your investments.
Be patient
One of the most difficult aspects of getting the benefits that come with compounding is having the patience to wait long enough for it to take effect. To optimize compounding requires at least 40-50 years, which is why you want to start investing as early as you can. Most of us aren’t Warren Buffett (who started investing at age 10), and don’t begin investing until we are older.
Before you do anything, meet with a financial professional
One of the most beneficial things you can do in your life in terms of long-term savings strategies is to use the power of compounding. However, before you make any financial decisions, take the time to consult with a financial professional. They can help you determine which investment option could align with your strategy and goals.
Important Disclosures:
Content in this material is for educational and general information only and not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by LPL Marketing Solutions
LPL Tracking #779023