Return to:Previous Page's Interactive Classroom

Course 111
Exploit the Magic of Compounding


Time is on your side.

A dollar invested at a 10% return will be worth $1.10 in a year. Invest that $1.10 and get 10% again, and you'll end up with $1.21 two years from your original investment. The first year only earned you $0.10, but the second generated $0.11. This is compounding at its most basic level: gains begetting more gains. Increase the amounts and the time involved, and the benefits of compounding become much more pronounced.

When compounding, the earlier you start, the better off you'll be. Let's consider the case of two investors, Joe and Sam. Say that Joe put $1,000 into the market at age 25 and earned a 10% aftertax return. Sam also put in $1,000 and earned the same return, but waited until he was 35 to do so. When both were nearing retirement at age 60, Joe ended up with $28,102, while Sam only has $10,834 from his investment.

To truly benefit from the magic of compounding, it's important to start investing early. After all, it's not just how much money you started with that counts, it's also how much time you've allowed that money to work for you.

Keeping Costs Down

With all the hoopla about day trading and technical analysis, why is it that billionaire day traders are few and far between? The answer: It's far better to hold stocks for long periods of time than to trade in and out of them often, racking up costs.

Unfortunately, the magic of compounding can work against you, too. If you trade a lot, you'll rack up taxes, commissions, and other expenses which, over time, compound. Every $1 you spend on commissions today could have been turned into $30 if you had invested that dollar at 12% for 30 years. Spend $500 today and you could be giving up $15,000 30 years hence.

The math gets even worse if you make lots of trades year after year. If you spend $500 every year on commissions, by the end of the 30 years you'll be $121,000 behind where you would have been if you had instead invested that $500 each year and earned a 12% return on the money. Even with commission rates that have dropped dramatically in recent years, commissions represent a powerful wind in the face of your investment returns. Whether you choose to walk against a gentle spring breeze or a raging storm is up to you.

The Tax Man

Commissions are just the beginning of the story because frequent trading can dramatically increase the taxes you pay. Let's take another example: Assume you invest $10,000 in a group of 10 stocks today that generates a 12% return (before taxes) and 28% short-term and 20% long-term capital-gains tax rates.

If you put $10,000 into these stocks and they rise at an annual rate of 12% for 30 years, and you subsequently sell them all and pay taxes on the gain, your original investment will turn into about $239,000, an 11.17% aftertax return. But by selling your stocks once per year, paying taxes on your realized gains, reinvesting what's left for another year, and repeating this process each year for 30 years, the same $10,000 will turn into just $120,000, an 8.6% aftertax return. That's another $119,000 you've just left on the table from taxes alone, in addition to the money flushed down the drain in increased commissions.

The 0% Loan

Think of it this way: Suppose you were offered a loan at 0% interest and told you could pay it back eventually, but only when you choose. Until then, you could use the money in any way you wanted. Would you take that loan?

Of course you would--you'd be a fool not to. Well, guess what? Both your stockbroker and Uncle Sam are offering you this deal every day. When you hold a stock for a long period of time and its value compounds, you're really getting a no-interest loan that you only have to pay when you sell the stock at a time and price of your choosing. What a deal!

All things considered, the mathematical benefits of being a long-term investor are just too big to ignore. It's no coincidence that most of today's accomplished investors think of the stocks they own in terms of years, not days.

Quiz 111
There is only one correct answer to each question.

1 Assuming a 10% aftertax return, who ends up with the most money at age 70?
a. Ann, who invests $1,000 per year starting at age 25.
b. Luke, who invests $1,500 per year starting at age 35.
c. Owen, who invests $40,000 at age 45 and $3,000 per year after that.
2 At a 10% aftertax return, how much money does Ann have at age 70, with her investing $1,000 per year starting at age 25? (Hint: think big.)
a. $350,000
b. $500,000
c. Over $750,000
3 Assuming an 11% aftertax return, how much money does one have to invest each year for 30 years to end up with one million dollars?
a. About $500
b. About $4,500
c. About $10,000
4 Beyond using IRA's and 401K's, how else can one avoid capital gains taxes?
a. By trading often.
b. By not selling.
c. By not filing a tax return.
5 To maximize the benefits of compounding, which does NOT need to be minimized?
a. Commissions.
b. Taxes.
c. Investment horizon (time).
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page