The Basics: Compound Growth

Famed theoretical Physicist, Albert Einstein is said to have once stated,

Compound growth is the most powerful force in the universe.

(It is actually highly disputed as to whether Einstein actually said these words but it gets the point across.)

Though I don’t know if I’d go as far as comparing it to universal forces, compound growth is definitely a powerful tool for growing money exponentially over time.

So, what exactly is compound growth and how does it work?

Compound growth is the process by which the gains you earn on an investment are reinvested to produce more gains that are also reinvested. This process repeats itself continuously, compounding the magnitude of your ultimate return.

Put simply, compound growth is making gains on your gains all while still making gains on your original investment as well.

Let's break it down visually.

Initial Investment
The image below represents your initial investment.

Growth Cycle #1
After one cycle of growth, your initial investment has generated some gains.

Growth Cycle #2
After the second cycle of growth we can see that, not only has your initial investment produced additional gains, but also your previous gains have generated their own gains.

Growth Cycle #3
Each cycle of growth, your initial investment produces more gains and every previous gain produces its own gains as well.

You can see how, over time, the growth really explodes. This is the power of compound growth.

Now imagine if you could apply this concept to your finances…

When you invest in the stock market over long periods of time, history suggests your money will grow. In fact, you’re likely to average a yearly return of 7-10%. But, it's not only your original investment that grows over time, all of the gains you earn along the way will grow as well. If that sounds familiar to you, then you’ve been paying attention because this is exactly the process we’ve been describing. Investing is the key to taking advantage of compound growth.

How about an example to demonstrate?

Peter has recently repaid all his debt using the strategies he learned on GoGreenDollar. As a result, he has decided to make a one-time payment of $1,000 towards his retirement savings. After 30 years, how will that $1,000 have grown?

Had Peter chosen to pile his money into a low-interest savings account (a very, very bad idea), after 30 years he would still have only around $1,000 saved.

If Peter had used the $1,000 to purchase a bond with a 10% yearly coupon (i.e. the yearly income), after 30 years we would have accumulated $3,000 in gains ($1,000 x 10% = $100 x 30 years = $3,000) to add to his original $1,000, giving him $4,000 total. This is an example of what’s called simple growth (similar to compound growth in some ways, but much less effective over time).

Peter, being a GoGreenDollar reader, would obviously have chosen to invest his savings in a stock index fund (with a few bonds for proper balance, of course). Let's assume a 10% rate of return. How does the compound growth Peter experienced compare to the other two options?

By taking advantage of compound growth, Peter has turned his original $1,000 into $17,450!

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We use Personal Capital regularly to analyze our investment fees, track our investments, and project our net worth. We also periodically review our progress toward retirement with their retirement planning calculator.

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