The Power of Compounding

It's amazing to me that the simplest principles in the world of finance are often the most overlooked. Granted, I don't expect CNBC and other financial news outlets to offer lessons on the basic concepts of finance but I can dream!

Vanguard, the massive mutual fund management firm that pioneered the index fund for individual investors, has a great article on the power of compounding on its website. Basically, compounding is the effect that you get when your earnings grow on top of prior earnings. These earnings can be in the form of interest, dividends, capital gains distributions or the like.

For example, if you have 1,000 shares of an index fund with a NAV of $10 which pays out a quarterly dividend of 0.25 in the 1st quarter, you will have $250 in dividend income. If you decide to reinvest that, come the next quarter, you will have 1,025 shares (holding the price of the fund constant). As the fund pays out its dividend of 0.25 in the 2nd quarter, you will subsequently receive $256.25 in dividend income. Imagine the results if you keep adding to this by investing systematically. All of this highlights a key principle that is proved true due to compounding: its easier to make money when you already have it.

That adage shouldn't discourage you - in fact, it should inspire you. After all, by starting at a age young like I hope members of Generation WISE are, you will begin to realize the full benefits of compounding investment returns. As your investments and savings grow from a young age, compounding will work its magic. Vanguard says that for compounding to work, you need to "start now, invest regularly and be patient." I couldn't have said it better myself.