Sunday, March 8, 2015

The Power of Compounding

The power of compounding is the multiplying power of growth times growth. Compound interest is such a powerful tool that Albert Einstein once called it the most important invention in all of human history. To illustrate the exponential power of compounding:  Ray got a jump-start, opening a retirement account at the age of 20 and investing P4,000 annually for the next 20 years. At 40, he stopped funding the account but left the money to grow at the rate of 10% each year.

Razel didn’t start saving for retirement until the ripe age of 40. Like his brother, Razel invested P4,000 annually, also with a 10% return, but she kept at it until she was 65 – 25 years in all. In sum, Ray, the early starter, invested a total of P80,000 (P4,000 per year x 20 years at 10%), while Razel, the late bloomer, invested P100,000 (P4,000 per year x 25 years at 10%).

Which of the two siblings had more money in his/her account at the age of retirement?

In this example, it was Ray, who’d gotten the early start and stopped saving before his sister had even begun, who ended up with almost P2.5 million. And it was Razel, who’d saved all the way until the age of 65, who had less than P400,000. That’s a gap of over P2 million. All because Ray was able to tap into the awesome power of compounding for an additional 20 years, giving him an insurmountable edge.

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