Question Of The Month –December  2009----
How can Compounding Help you To Build 
Your Retirement nest egg?

 How easy - difficult is it to become a millionaire?  Is it possible to build a $1 million nest egg?   Difficult but not impossible thanks to a steady dose of savings and the magic of compounding.

 In our third in a series of columns on the basic concept of saving and investing, we will look at compounding.

 John T. McCarthy, in his book, Financial Planning For a Secure Retirement, shows us the not too impossible or not too difficult road that we have to follow.  You begin by investing $1,200 a year ($100.00 a month or $3.33 a day).  We will have to assume an excellent annual return of 12 percent;  not easy but not impossible. 

 The average annual return with stocks over a seventy year period is 11 percent.  Ibbotson Associates reports a compound total annual return of 13.1 percent since 1948.  McCarthy states, "It should be pointed out that good quality stocks, over the long term, have been able to post returns in this neighborhood (12% annual return) when both dividends and capital gains are reinvested.  The operative words here are quality, long term and averaged. 

 What can happen when you leave your investment in the market for 40 years?  Let's look at the chart.

 Amount invested

Years    at $100 a month     at 6%      at 12%       Difference

10           $12,000        $16,766     $23,586      $6,820

20            24,000         46,791      96,838       50,047

30            36,000        100,562     324,351      223,789

40            48,000        196,857    1,030,970     834,113

McCarthy refers to this as a "get-rich slow scheme."

What's the secret?  The long-term power of compounding.  With compounding, you take advantage of the time you will have until you retire.  The more time you have on your side, the longer period of time your money will have to grow.  And that means more money when you retire.

 Compounding is the principle that if you reinvest the earnings on your investment, those investment earnings will earn additional earnings and thus enable your asset to grow over time.  When you give your retirement savings as much time as possible to grow, you give compounding more time to work for you.  Ben Franklin explained the concept by saying, "The money that makes money, makes money."  With tax deferred investing (401(k), 403(b), 457 plan), your investment dollars work even harder because no taxes are paid on investment earnings until the money is withdrawn.  And, if your company has a match for your plan, you are even further ahead.

Eighty-seven percent of companies that offer a 401(k) match their employees contribution at some percentage. 

 Wayne Bogosian and Dee Lee point out in their book, "The Complete Idiot's Guide to 401(k) Plans" that compounding can work against your when you borrow money or extend yourself credit on credit cards.  "Why do you think banks and credit card companies charge you daily interest on your mortgage or credit card balance.  They know that compounding works, too."

 The power of compounding is illustrated in The Rule of 72 developed by Venita Van Caspel in "Money Dynamics for the 1990's (Simon and Schuster, 1988).  The Rule of 72 approximates how long it will take you to double your money using different rates of return. 

 Rule of 72 Formula:  (72) - (interest rate) = number of years needed to double your money.  The number 72 divided by the interest rate (return) will give you the approximate number of years it will take to double your money,  Example:  If you want to double $1,000 at an interest rate of 8 percent, it will take you approximately nine years for the $1,000 investment to double to $2,000. 

(72 - 8 = 9 years to double your money from $1,000 to $2,000).

 It is never too late to start to use compounding to build your next egg but the earlier you start, the better off you will be.  

Some of the experts state that compounding interest may be the greatest mathematical discovery of all time.