By Brian Adams
The Magic of Compounding
Grace Groner lived in Lake Forest, Illinois, about 45 minutes north of Chicago. After graduation, Grace was hired as a secretary at Abbott Laboratories. She worked there for more than four decades. According to the Los Angeles Times, she got her clothes from garage sales (as she never earned an amazing salary) and she lived in a one-bedroom house that was willed to her by a friend.
Soon after starting her job in 1931, she bought three shares of the company’s stock for about $60 per share. Her total investment was under $200. Grace never sold these shares. Through dividends, share splits, and dividend reinvestment her small investment multiplied significantly. When she died in 2010, her three share purchase was worth $7 million. She left it all to her alma mater.
What we learn from Grace Groner’s story is that she invested only $200 for 75 years and took advantage of the power of compounding for a lifelong period to become a multi-millionaire. You may not have the same time horizon as Grace Groner, but this example shows how it takes the least amount of effort to build wealth using the magic of compounding.
What is Compounding, also referred to as Compounding Interest?
While Albert Einstein may have called compounding one of the greatest mathematical concepts of our time, I call it the most magical way to get rich. Compounding is simply when an investment generates earnings, which are then reinvested to generate their own earnings. So, you are earning interest on interest or getting paid dividends on dividends over a long span of time. Additionally, compounding is what happens when the money you save in a savings account, stock account, mutual fund, or an employer-sponsored retirement account (such as a 401k) grows, and then that monetary growth remains in your account to be reinvested earning you even more.
What you should know is that compounding is a long term investment. Therefore the earlier you start saving, the longer your money will grow. However, anyone can take advantage of a compound interest investing program.
Four important things to determine how your money will compound:
- The profit you earn on your investment. For example, if you are investing in stock, this would be your total profit from capital gains and dividends or interest income on a savings account.
- The length of time you can leave your money to compound. The longer your money remains uninterrupted, the bigger your fortune can grow. It is no different than planting a tree. Naturally, the tree is going to grow with the passage of time.
- The tax rate and the timing of the tax you have to pay to the government. You will earn far more money if you do not have to pay taxes at all or if the taxes are deferred. That is why accounts such as a Traditional IRA or Roth IRA, 401(k), SEP IRA, and the like are a favored investment vehicle.
- The risk you are willing to take with your money. You probably have heard the saying “No Risk, No Reward.” Risk will determine the return potential, and ultimately determine whether compounding is a realistic expectation. One catastrophic year could take the benefits of compounding interest off the table. Compounding is based on an assumption that gains will occur every year.
The Mathematics of Compounding on a Long Term Investment
Let us assume you make a one-time investment of $10,000 at an annual return rate of 6% compounded monthly. By the end of the first year you would receive $617 in profit. Instead of spending the profit, you decide to reinvest the $617 back into your investment account. If you leave the $10,617 invested for Year 2, you will receive $655 in profit by the end of that year, $38 more than Year 1. By Year 10 your $10,000 investment would grow to $18,194, by Year 20 to $33,102 and Year 30 to $60,226. You will more than quintuple your money just by letting it sit and grow – that is the power of compounding!
Or, if you want your $10,000 investment to yield $200,000, instead of $60,000, simply be more judicious with your choice of investment vehicle and select a vehicle that will yield a 10% return (we will discuss various investment vehicles later).
SUPER CHARGE: The Power of Compounding With a Monthly Investment Plan
If you want to supercharge the compound effect and truly EXPLODE your wealth, you can direct additional funds to your initial investment and really see the power of compounding. Your same $10,000 investment (at 6%), plus an additional $100 payment per month can grow to $34,582 in 10 years, to $79,306 in 20 years, and your total contribution of $46,000 will become $160,677 by year 30! That is the power of compounding. If you model that in a 10% investment vehicle, your same $46,000 investment will yield almost half a million dollars after 30 years.
Don’t have $10,000 to get started? No problem. Try allocating $25 a week (that is only $3.50 per day!), without the initial $10,000 lump sum. A $100 per month annual investment for 30 years at just 6% per year, compounded monthly, can yield over $100,000 and you would have almost tripled your $36,000 investment at the end of 30 years. If you increase your investment to $400 each and every month, your investment dollars would grow to over $400,000.
It looks easy — and it is. Compounding takes a while to build up steam and time is the most important element when it comes to compounding. The earlier you start investing, the more years your investment dollars can compound and the larger your investment will grow.
Achieving Financial Freedom Through Compounding
Some individuals are fortunate to inherit wealth, some have hit the lottery or on games of chance, yet the strategy of compounding is proven and available. Harnessing the power of compound interest for your personal wealth is similar to the quote below:
“The best time to plant a tree was 20 years ago. The second-best time is today.”
This investing strategy is very powerful. It means that no matter where you are in life, and no matter what mistakes you have made in the past, now is the time to change your future. Start planting your orchard today. It is never too late when you have made up your mind to get started. It only takes the money you have in your hand right now, whether it is $100 or $1,000,000. You are in control of your financial destiny.
We also saw previously that thoughtful alignment of your compounding strategy and the right investment vehicle can allow you to achieve your personal wealth goals much more quickly. So, your next decision will be what investment vehicle (money market, stock, mutual fund, real estate, etc.) will you use to gain your financial freedom?
During my many years working with high net worth individuals and other investors, I have come to believe that the only real option to create true wealth is by investing in real estate. Income producing properties, such as multi-family housing units (e.g. apartment buildings) create fantastic investment vehicles for individuals working towards true financial freedom. Where else can you receive both a return on investment in the form of positive cash flow PLUS a built-in compounding effect from appreciation? Investing in stocks, money markets, mutual funds, etc. allows you to take advantage of compounding, but only if you place your proceeds back into the same investment. Real estate offers the greatest level of control and profit potential. While Andrew Carnegie famously said that “90% of millionaires made it through real estate,” I would venture to say that 99.9% of billionaires have real estate in their wealth portfolio.
Additionally, as a real estate investor who owns both single family homes and apartments, I believe there is no better choice for achieving financial freedom than investing in apartment buildings. Why apartments?
- Apartments have greater profit and cash flow potential compared to single family homes
- Apartments are easier to manage, since all the tenants are in one location
- There is significant demand for apartments due to recent single family home foreclosures, everyone needs a place to live
- You can create appreciation by simply increasing rents or decreasing expenses
Now that you are informed and excited about the power of compounding, how can I help you to create massive wealth? Let me share with you information on my preferred investment vehicle. I follow a conservative investment strategy and partner with investors to acquire cash flowing properties. If you have interest in learning more, contact me today at: Brian@AdamsInvestorGroup.com or at 215-681-0061.