Make Compounding Work for You

Taking advantage of compound interest need not be a passive strategy on your part. The bigger your investment base, the more that time and math will conspire to build up your wealth. That is why investment advisors suggest taking advantage of time and a schedule of periodic investing. The results build on themselves.

You can maximize the power of compounding by following a few easy strategies:

Invest early. The longer your money has time to work for you, the better compounding works. In fact, the effect is far more dramatic the earlier you begin and the longer you stay invested. So, the sooner you can begin investing, the more interest or dividends, and hence growth of your principal, you will accumulate through compounding. Invest often. Adding to your investments on a regular basis such as monthly or weekly can build your wealth quickly. The accumulation builds the base on which your interest is calculated. To stay on a schedule for periodic investing, some people take part in automatic investment plans, in which money is taken out of their deposit accounts and put into their chosen investments. Reinvest your dividends. If you own shares in a stock or mutual fund, you may be able to reinvest your dividends into more shares. This continues to build your investment base, allowing you to compound your return. It's putting your new income to work for you.

The example below shows the power of compounding, using an 8% rate. Note that as the years increase, the curve gets steeper and steeper. This pattern attests to the way that compounding builds on itself to raise the speed at which your wealth accumulates.

Compound Interest over Time

This example assumes an 8% interest rate. Many investments, such as savings accounts, bonds, and certificates of deposit, will earn lower rates; but others, such as stocks and mutual funds, may earn upwards of 10%, 11%, or higher. These equity investments have an unlimited earning potential and have historically earned better than savings accounts and certificates of deposit. Many investors choose them to take advantage of the power of compounding.