Tuesday, September 29, 2009

If You Love Compounding, Compounding Will Love You

Let's say your retirement savings have been pummeled in the last couple of years. You've lost faith in the stock market, and haven't jumped back in notwithstanding this year's rally. You're in good company, as numerous long term investors (such as individuals saving for retirement) haven't taken the bait on the current bull market, or bear market rally, or whatever it will turn out to be with the benefit of hindsight. They prefer to avoid loss, and given recent history, that's not a bad strategy.

But we still have the question of what to do financially about the future. Bear in mind the simple power of compounding. Compounding comes about when you save and reinvest the income from your savings. It is particularly effective when you add to your savings regularly, like every pay day. Look at the following example.

Assume you're 15 years away from retirement and you can barely bring yourself to look at your 401(k) account statements. In the past you weren't so committed to building the account and you now have a recession-diminished balance of $100,000. You understand that, more than ever, you're responsible for making your retirement years golden. You resolve that you're not going to have dog food as part of your diet in old age, and seriously rearrange your financial priorities so that you can contribute the maximum amount permitted by IRS regulations to your 401(k), currently $16,500 a year. You've had it with the stock market and decide to stick to high quality bonds. We'll assume you can earn an average return of 4% per year on your all-bond portfolio. At the end of the remaining 15 years of your working life, your 401(k) account will have a balance of approximately $510,000. If we assume that inflation runs at its historic average of 3% per year, your inflation adjusted balance will be about $323,000.

In other words, if you buckle down now and max out your 401(k) for the rest of your career, you can give your retirement account balance a very large boost, even with modest returns and adjustment for inflation. This is what compounding does. By saving more each pay day and reinvesting your returns, you can leverage up your retirement savings dramatically.

Most of the financial advice you see on the Internet and in other news media focus on an endless array of investments, strategies, choices and decisions. But much and perhaps most of the mileage you can get from your capital comes from compounding. Your choice of investment strategies and the allocation of your portfolio may give you greater or lesser potential profits, at the risk of greater or lesser volatility. But the discipline of saving on a compounded basis is the foundation on which everything else rests. If you love compounding, compounding will love you.

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