Power of compounding interest.

[NothingInCommon]

Everyone talks about its obvious advantages, but does it even exist anymore?

If so, please enlighten me. I would love to open an account. I'm not looking to get rich quick, as a matter of fact, I try to never take any risks at all apart from the risk that the insurer of my "guaranteed" 401k fund will go insolvent.

[disneysteve]

Of course it exists. If the portfolio of investments in your 401k earns an average return of 8%/year, which is a perfectly reasonable goal, your money will compound year after year after year until retirement.

There is no such thing as not taking any risks with your money. Every decision you make involves risk. If you stick with "guaranteed" things like a CD or money market, you are guaranteeing that you will lose ground to inflation each year and almost certainly not amass enough money to ever retire. That is a huge risk. If, however, you build a diversified portfolio with stocks and bonds, there is not a guaranteed return but there is a far greater chance that you will outpace inflation by several percentage points each year and benefit from the power of compounding.

[NothingInCommon]

Of course it exists. If the portfolio of investments in your 401k earns an average return of 8%/year, which is a perfectly reasonable goal, your money will compound year after year after year until retirement.

There is no such thing as not taking any risks with your money. Every decision you make involves risk. If you stick with "guaranteed" things like a CD or money market, you are guaranteeing that you will lose ground to inflation each year and almost certainly not amass enough money to ever retire. That is a huge risk. If, however, you build a diversified portfolio with stocks and bonds, there is not a guaranteed return but there is a far greater chance that you will outpace inflation by several percentage points each year and benefit from the power of compounding.

I understand that there are risks.

Is a rate of return the same as compounding interest? I am not being sarcastic, I genuinely don't have a clue. I thought it was more like simple interest..

You are saying that with me merely being in a 401k I am earning compounding interest? I

I just want to take the money I earn and put it in a safe place while earning compounding interest not simple interest.

Please help

[disneysteve]

Is a rate of return the same as compounding interest? I am not being sarcastic, I genuinely don't have a clue.

Let's say that you invest $1,000 in your 401k. Over the next 12 months, it earns 8%, so you end up with $1,080 as $80 is 8% of $1,000. Over the following 12 months, it again earns 8% except now your basis is not $1,000, but rather $1,080 so 8% of that is $86.40 so at the end of the 2nd year, you'll have $1,166.40. If year 3 also sees an 8% return, you'll earn 8% of $1,166.40 which is $93.31 for a total of $1,259.71.

Simple interest refers to what the investment is actually earning.

Compound interest refers to the fact that the initial investment earns interest and then, if left alone, the interest earns interest as it all gets added to the principle.

[scfr]

Yes, compound interest still exists. Here are real world examples. I currently have 2 CDs. One is a 5-yr CD that has an interest rate of 4.89% with an APY (annual percentage yield) of 5.00%. The other isa 10-yr CD that has an interest rate of 5.746% with an APY of 5.91%. The difference between the interest rates and the APYs is the effect of compounded interest. Interest on both accounts is compounded monthly. The interest earned each month stays in the account. So I end up "earning interest on the interest earnings."

Moving away from real-world numbers, let's say just for example that I had opened that first CD with $1,000. After a month, if it's a 30-day month, I would have earned $4.02 in interest, so my account balance would be $1,004.02. If the following month was also a 30-day month (as I said, I'm no longer using real-world numbers, so no one needs to point out that you will never have two 30-day months consecutively), you would earn $4.04 in interest ... 2 cents more, because the amount you are earning the interest on has increased. And on it would go ... you would earn more & more interest as time goes on because of the power of compounded interest. The 2 cents difference between the first and second month doesn't seem like a lot, but over time it adds up.

A couple observations:
- During times like the ones we live in, when interest rates on savings are low, the compounding of interest seems less impressive.
- As much as I respect Disneysteve & agree with him much more often than not, I must say that I disagree 100% with his statement "If you stick with 'guaranteed' things like a CD or money market, you are guaranteeing that you will lose ground to inflation each year" ... My experience has been the exact opposite over the past 20 years of putting money in CDs and Money Market Accounts. I have always had returns that outpace inflation. Granted, during those 20 years we have never had a period of "hyperinflation" and I will not say that you are going to be guaranteed to outpace inflation, but you are most definitely NOT guaranteed to lose ground to inflation. I think that the primary difference between Steve & I is that he has admitted he is not interested in being a "rate chaser." I on the other hand am not ashamed to admit that I am an ardent "rate whore." I will pick up my money & move it to another financial institution if I can earn more interest. I consider finding the best rates to be had one of my most important "personal finance chores." For me, spending the time & energy to do that is absolutely worth my time. I will also lock up some of my cash in longer-term CDs when I feel the getting is good. Neither approach is right or wrong. Steve's approach works for him, and mine works for me.

[ETF Trading Strategies]

The real power of compounding comes with the passage of a long period of time. Its not exciting for most people looking for a quick turn, but after 10+ years compounding investments become extremely attractive, particularly when re-investment of proceeds is done each year. Dividend reinvesting is a good example.