Compounding is interest earning interest and it is powerful because as the interest that is earned by the initial capital also earns interest, the value of the account grows at a geometric (ever-increasing) rate, rather than an arithmetic (straight-line) rate.

AN EXAMPLE OF HOW COMPOUNDING WORKS

Two investors have $1,000 each to invest every year in a mutual fund, leaving the dividends to compound. Investor A's fund provides an 7.9% annual return, while Investor B's fund returns only 4.1%. While Investor A's rate of return is twice that of Investor B's, over time the increase is significantly more than twice as much. After 10 years, Investor A's gain is 2.2 times greater, and after 20 years, it is 2.6 times greater.

 

                     Investor A     Investor B    
Rate of return          7.9.0%          4.1%
10-year gain             44.9%         20.1%
20-year gain            128.8%         48.9%

 

Remember that examples in articles and on the website are for illustrative purposes only and do depict the actual performance of any fund. A mutual fund's investment return and share value will fluctuate.

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PUT COMPOUNDING TO WORK FOR YOU

Reinvest dividends

Instead of taking your mutual fund's distributions in cash, instruct your fund to let them remain in your account to purchase additional shares. Most companies will allow you to do this without paying an additional sales charge.

Invest regularly

Add to your mutual fund account on a regular basis, perhaps monthly or quarterly. You may be able to have this done automatically by setting up a systematic investment plan with your mutual fund company. By investing regularly you take advantage of a strategy called dollar-cost averaging.

Make time your ally

The longer your money can work for you, the better compounding works. Consider this: $1,000 invested at 8% earns $80. Left to compound, the original $1,000, plus accumulated interest, will earn $160 in the 10th year, $507 in the 25th year, and $1,609 in the 40th year -- returns of 16%, 51%, and 161%, respectively, on the original $1,000.

Roger Sorensen

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