Compounding and Time

IMAGINE A BROTHER and sister, who are twins. The sister saves $5,000 a year for 10 years, from age 25 to age 35, earning 6% a year. At age 35, she would have $69,858. She doesn’t add any more money to the account. Instead, she leaves the $69,858 to grow at 6% a year for another 30 years, until age 65. If you compound at 6% a year for 30 years, your cumulative gain would be 474%, equal to 5.74 when expressed as a decimal. To find out how much the sister would have at age 65, you would perform this calculation:

$69,858 x 5.74 = $400,985

Meanwhile, her twin brother gets off to a slower start. He doesn’t start saving until age 35, which is when his sister stops. To have roughly the same sum at age 65 as his sister, the brother would have to save $4,785 every year for 30 years, from age 35 to age 65. That isn’t significantly less than the $5,000 that his sister had to save every year for a mere 10 years to accumulate the same sum, thus illustrating the power of starting early.

As you might gather from the various examples above, you can accumulate greater wealth if you start with a larger initial investment, save more on a regular basis, start earlier (and hence save and invest for longer), earn higher returns, reduce unnecessary volatility and defer taxes.

Next: Present vs. Future Value

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