You’ve probably come across your fair share of retirement tips. It can feel overwhelming with so many moving parts. But perhaps the most nerve-wracking part is wondering if your money will grow enough to support a comfortable retirement.
Here’s the deal: Saving alone likely won’t get you to your target number, which for many people is around $1 million or more. The real mover and shaker? Compounding. It’s one of the most powerful tools in investing. Even legendary investor Warren Buffett swears by it.
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The power of compounding never goes out of style
The term “compounding” has been thrown around for centuries, but you might not fully realize just how powerful it is. In simple terms, it’s the beauty of watching your interest earn interest and your dividends earn dividends. Compounding is the secret that can turn small savings into a substantial nest egg over time.
Let’s break it down. Imagine you kick off your retirement savings with $10,000. You could store that money in various places — your home, a savings account, a retirement plan, or a brokerage account. If you stash that $10,000 under your mattress and leave it there for 10 years, guess what? You’ll still have $10,000 — no more, no less. In this scenario, you miss out on the benefits of growth and compounding altogether. Your money is simply on an extended vacation, not working for you at all.
Now, let’s say your money grows 5% each year, but it’s not compounded. That means your $10,000 will earn $500 of interest in the first year, $500 in the second, $500 in the third, and so on. Your savings would grow from $10,000 to $10,500, to $11,000, to $11,500. That sounds like a better deal, but compounding is much sweeter.
With compounded growth, your money works even harder. After the first year, you would still have $10,500. In the second year, you’ll earn interest on the $10,500, bringing your total to $11,025. By the end of the third year, your savings would grow to $11,576.25. As you can see, compounding allows your money to grow faster every year.
Let’s take it one step further
You can really see the power of compounding take off when you invest in the stock market. But keep in mind, it’s not foolproof — market swings can cause dips in your portfolio when things move in the opposite direction.
For example, say you invest your retirement savings in the S&P 500 index, which follows the 500 largest publicly traded companies in the U.S. Historically, the S&P 500 has delivered an average annual return of around 10%, so we’ll use that for simplicity’s sake. At that rate, here’s how your $10,000 portfolio could grow through the power of compounding, assuming you reinvest your profits each year:
| Year | Starting Balance | Earnings | Ending Balance |
|---|---|---|---|
| 1 | $10,000 | $1,000 | $11,000 |
| 2 | $11,000 | $1,100 | $12,100 |
| 3 | $12,100 | $1,210 | $13,310 |
| 4 | $13,310 | $1,331 | $14,641 |
| 5 | $14,641 | $1,464 | $16,105 |
| 6 | $16,105 | $1,611 | $17,716 |
| 7 | $17,716 | $1,772 | $19,487 |
| 8 | $19,487 | $1,949 | $21,436 |
| 9 | $21,436 | $2,144 | $23,580 |
| 10 | $23,580 | $2,358 | $25,937 |
Calculations by author. Numbers rounded to the nearest dollar.
This is an example of how your money could grow if you make a lump sum investment into an account and don’t add any additional funds. In reality, you’ll probably make regular contributions to your retirement savings throughout your career. So, if the numbers above aren’t too exciting, take a look at how the power of compounding can get you to the million-dollar mark if you’re consistently contributing and investing over the long run, assuming the same 10% return.
| Number of years | Amount contributed per month | Total savings |
|---|---|---|
| 20 | $1,500 | $1.031 million |
| 30 | $525 | $1.036 million |
| 40 | $200 | $1.062 million |
Data source: Author’s calculations via investor.gov.
There are many popular Warren Buffett quotes floating around online, but one that stands out is: “Time is your friend; impulse is your enemy. Take advantage of compound interest, and don’t be captivated by the siren song of the market.” This quote teaches us that if you start early, avoid the noise, and let compounding work its magic, you could enjoy a nice payoff later. The market won’t always behave the way you want, but compounding can still help you build exponential wealth over time.
