The Importance of Starting Early

You may have heard it said that the best time to plant a tree is 20 years ago; the second best time is today. The same is true of investing. It's never too late to start, but the earlier you start, the harder your money can work for you to help you reach your financial goals - thanks to the power of compounding.

Compounding refers to the growth of an investment's earnings. For example, if you invest $1,000 and earn 5 percent per year, your initial investment is worth $1,050 after one year. If you reinvest that $50, your earnings during the second year are based not only on the original $1,000 investment, but also on the $50 of first-year earnings. So, at a 5 percent return, instead of $50, during the second year you will earn $52.50. The $2.50 difference between what you earned in year one and what you earned in year two is the effect of compounding. At the end of the second year, your investment will have grown to $1,102.50.

Reinvestment is the mechanism by which compounding works. Many investments offer the option of taking your earnings in cash instead of reinvesting them. But by "cashing out" your earnings, you don't allow compounding to work for you. Over long periods of time, the magic of compounding can produce significant growth in the value of an investment. Let's take a look at some examples.

Example One

The following graph shows three investors, each of whom invests $1,000 a year until age 65. However, one begins at age 25, investing a total of $40,000; one at age 35, investing a total of $30,000; and one at age 45, investing a total of $20,000. Each earns 7 percent per year and, for purposes of this illustration, the effects of taxes and inflation are ignored.

The Power of Compounding

Source: Investment Company Institute

Conclusion: Because of compounding, the earliest investor retires with more than double the one who waits until age 35 and more than four times the one who waits until age 45.

Example Two

Here is another example comparing two investors. One gets off to a fast start, investing $1,000 each year for 10 years beginning at age 25 for a total of $10,000 invested, then adds nothing more for 30 years. The other starts later and invests longer, investing $1,000 each year beginning at age 35 and continuing until age 65 for a total of $30,000 invested. Each earns 7 percent per year and, for purposes of this illustration, the effects of taxes and inflation are ignored. The graph below shows where each investor stands at age 65.

The Importance of Starting Early

Source: Investment Company Institute

Conclusion: Because of compounding, the fast starter can earn two-thirds more on only one-third of the amount invested by the one who starts later. The sooner you start to save, the less you need to save to reach your goal.

Example Three

If saving for your children's education is one of your long-term goals, it needn't be daunting despite the high costs of college. Suppose, when your child is born, you decide to start taking your lunch to work instead of buying it. You figure that saves you $4 a day, or about $80 a month. Let's say you invest that money in an account that earns, on average, 7 percent per year. The graph below shows how the money grows with your child.

According to the U.S. Department of Education, more than two-thirds of all students attending four-year colleges today pay $8,000 or less per year in tuition and other fees. So for many of today's 18-year-olds, that $80 per month could have completely financed their college educations.

A Head Start on Saving for College

Source: Investment Company Institute

Conclusion: Because of compounding, forward-thinking parents can be prepared for their children's college education costs. By starting early enough, you can reach your goal even with relatively small amounts.