The "Magic" of Compounding, Explained

Disclosure: I’m excited to be working with    Ellevest    to start this conversation about women and money. I receive compensation if you become an    Ellevest    client.

Disclosure: I’m excited to be working with Ellevest to start this conversation about women and money. I receive compensation if you become an Ellevest client.

Question: When is a dollar not worth a dollar?

Answer: When it’s invested. 

Historically speaking, a dollar invested today is worth even more than a dollar invested later. Consider this: Every single day you wait to invest can cost you about $100. That’s like giving yourself a pay cut of over $17 an hour. Or nearly $3,000 a month. Yup.

But why? One word: compounding.

How does compounding work?

Let’s say you invest $100, and that money earns a 6% return every year. (That would be unusually consistent, but this is just to use as an example.) Well, 6% of $100 is $6, right? Right. So here’s how you might assume that would look:

Year 0 (when you start): $100 
Year 1: $100 + $6 = $106 
Year 2: $100 + $6 + $6 = $112 
Year 3: $100 + $6 + $6 + $6 = $118 
Year 4: $100 + $6 + $6 + $6 + $6 = $124 
Year 5: $100 + $6 + $6 + $6 + $6 + $6 = $130 
Total returns after 5 years: $30

But that’s not actually how investing works. You don’t just earn 6% of your original $100 investment every year. Instead, as long as you leave it all invested, you earn 6% on the total balance of your account every year:

Year 0 (when you start): $100 
Year 1: $100 + ($100 x 6%) = $106.00 
Year 2: $106.00 + ($106.00 x 6%) = $112.36 
Year 3: $112.36 + ($112.36 x 6%) = $119.10 
Year 4: $119.10 + ($119.10 x 6%) = $126.25 
Year 5: $126.25 + ($126.25 x 6%) = $133.82 
Total returns after 5 years: $33.82

Your ending balance is higher when the returns are compounded. That’s the magic. (OK, it’s math, not magic.) And while a difference of $3.82 in this simple example may not seem like much … imagine what this could look like when you’re talking about a retirement account — with a balance of potentially thousands of dollars (instead of $100) and a timeline of 40 years (instead of 5). And say you make investing a habit and put in some money out of each paycheck, so you keep adding to that balance? Yeah. It adds up fast.

To put that into perspective:

You, right now, probably: That all sounds well and good, but … um … markets go down, too. What happens if it’s -6% instead? Good question. Compounding does have a dark side — like when we’re talking about compound interest on your credit card (ouch). And yes, if the markets were to decline for a big chunk of the time you had money invested, it would work against you — that’s why we say that investing comes with risk.

BUT. The longer you let compounding work its mathemagic, the more likely you are to have overall positive returns (at least, that’s been the case historically).

Case in point: Stocks are typically the riskiest part of an investment portfolio, and they’ve gone up in about 75% of years since 1928 — in fact, the stock market has returned an average of 9.5% a year.

Thanks to the power of compounding returns, money that you invest can potentially earn more and more every year.
— Sallie Krawcheck

That’s why investing can be more useful than simply saving if you want to hit your money goalsbuild wealth, and take advantage of the market’s historical long-term growth.

And every day you wait is a day you miss out on the opportunity to start compounding. 

There’s no time to waste.