Talking Volatility: Magnitude vs. Percentage
Unfortunately, as human beings, we are prone to behavioral tendencies and mental shortcuts that do not always work in our favor.
If you are like most people, you need your investments to grow to achieve the life you want. Fortunately, there is a deceptively simple but exceptionally powerful tool that can help you produce that growth. It is called compounding, and it is the process of earning investment returns on your past investment returns. Compound returns are such a big deal that they have been called the eighth wonder of the world (an expression likely misattributed to Albert Einstein).
What puts compounding on par with the Great Pyramid at Giza? It can help your portfolio grow exponentially over time.
Take this simplified (very) hypothetical example:
The more your investments grow, the more you can reinvest in pursuit of more growth.
You can pull a couple key levers to make the most of compounding. Using them wisely could give your savings a considerable boost. Let’s take a look.
In investing, time makes it possible for wealth to snowball. The longer you can allow your investment returns to compound, the greater the snowballing effect can be.
Thanks to compounding, money you invest early can become much more valuable than money you invest later in life. Many investors already get this on an intuitive level. But it can help to understand a numerical curiosity that explains why compounding works so well.
Consider the following simplified example:
Investor 1, age 30, invests $10,000 dollars a year for 10 years and earns a 7% annual return. At the end of the decade, they have contributed $100,000. At that point they stop making contributions and leave their money to keep earning 7% annually.
Total portfolio value at age 65: $802,370
Investor 2, age 40, is trying to catch up. They invest $10,000 a year for 25 years, and they also earn a 7% annual return. Their total contributions add up to $250,000. Their portfolio’s value at age 65 is about $125,000 less than Investor 1, even though they contributed $150,000 more.
Total portfolio value at age 65: $676,765
The Upshot: The earlier you can start investing and taking advantage of compounding, the better.
Taxes can sap compounding’s strength. If you hold investments in a taxable account, their interest payouts, dividends and realized capital gains can trigger taxes that effectively reduce your annual return. Lower effective returns leave less money to grow the next year.
It is a different story if you hold your portfolio in a tax-advantaged account such as a 401(k), traditional IRA or Roth IRA. You do not pay taxes on money while it is in these accounts, so every dollar of gains can go to work for you.
That is not to say you will not pay taxes eventually. You contribute pre-tax money to traditional 401(k)s and IRAs, and it can grow tax-deferred while in the accounts. When you withdraw money after age 59½, the money you take out will be taxed at normal income tax rates. In the meantime, however, tax-advantaged compounding can help you build a considerably larger nest egg.
Roth accounts, on the other hand, are funded with after-tax dollars. Money inside the accounts grows tax-free, and you do not pay taxes on withdrawals made after age 59½. In essence, any compound investment growth in a Roth is tax-free.
The Upshot: Investing inside tax-advantaged accounts can help your portfolio grow faster by preserving more of any growth for longer.
Like most things in life, investing includes many elements you cannot control, so it is essential to focus on what you can, especially those moves that help you make the most of compounding. That is why starting early, staying invested for the long term and capitalizing on tax-advantaged accounts are critical for investing toward your long-term goals.
This post was written and first distributed by The Writing Company.
DISCLAIMERS
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.
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