One of the most important concepts in finance is compounding. Compounding is interest earned (or charged, in the case of a loan) on interest previously paid (charged). For an investment portfolio, compounding is returns on returns. The positive impact on a saver’s (negative on a borrower’s) wealth increases exponentially with time. Since April is Financial Literacy Month, we demonstrate the concept here and give you an easily scalable table to use for estimating future wealth.

Compound Interest

A key component of financial literacy is the concept of compound interest. The first interest payment is based on the starting balance. Assuming no withdrawals, all interest paid thereafter will be based on both the original balance and all interest income (“interest on interest”). This fact allows a savings account earning a 2% interest rate to grow to $110.41 (instead of $110) in five years. The same concept works for loans, with the absolute amount of interest charged growing if the principal amount is not paid down.

Time Also Builds Wealth

Initially, the benefits of compounding on a portfolio are small. With the passage of time, the amount earned from compounding grows exponentially, leading to ever larger increases in wealth as percentage returns are realized off of bigger and bigger account balances. For example, a $1,000 portfolio realizing a 10% annualized return (which is equivalent to the long-term return of large-cap stocks) will grow to more than $17,000 if left unchanged for 30 years.

How Time and Return Intersect

The length of time you can invest for and the amount of the return you realize are both key determinants in how much wealth you will have. This table shows what a $1,000 starting balance will grow to, assuming no additional contributions, at a given rate of return and investment period.

Discussion

DonB from OR posted over 7 years ago:

This would be a good place to introduce the rule of 70.

Rico from MI posted over 7 years ago:

I agree with DonB. In fact, I am disappointed that it was not included in this article. Once learned, the rule of 72 can be calculated in you head, or if needed a simple calculator. This would be much more effective at improving financial literacy than the spreadsheet in this article.

Steve from WI posted over 7 years ago:

I never knew about the rule of 70 until DonB mentioned it, but I am very familiar with the rule of 72. I did some research and also learned about the rule of 69.3. The difference has to do with how compound interest is calculated, how accurate of a result you want, and the ease of doing calculations in your head(how 72 can be easily and evenly divided by many numbers). For in my head calculations I will stick with the rule of 72. I do agree with DonB and Rico-it should be included in the article.

ARMAND C from CO posted over 5 years ago:

There is also the Rule of 240. That is one dollar compounded at 10% grows to $10 in 24 years. Conversely at 24% $1 grows to $10 in 10 years. Or $1 grows to $10 in 12 years at +/-20%, etc. The rules of 72 and 240 are not exact, just approximations. They just help give a sense of magnitude.

David L from AK posted over 2 years ago:

Good article, AAII staff. And good suggestions, Don, Rico, Steve, and Armand. Because of your comments I'll brush-up on the approximators. thx, Folks.

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