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What Is Compounding?

moneyCompound interest or compounding is what happens when interest earned on an investment is added to the original investment to earn more interest.

It is one of the most powerful concepts in investing. It is supposed to have led Albert Einstein to label compound interest as the Eighth Wonder of the World. He is even reckoned to have said that those who understand it earn it, those who don’t pay it.

Perhaps one of the most powerful examples of compounding is provided by two people who both save equal amounts ever year for their retirement.

Person A starts at age 19 and contributes $2,000 annually into an investment for seven full years, then stops contributing but still allows the investment to continue to run for another 40 years. Person B on the other hand doesn’t start investing $2,000 a year until age 26, and continues to invest for the next 39 years.

If we assume that both investments deliver 10% return a year, then both A and B will end up with similar sized pots at the age of 65. However, the big difference is that A will only have contributed $14,000 over seven years, while B will have paid in $80,000 over 40 years.

The main point is that it takes time for compounding to work. So, the earlier you start, the better.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.