One of the most important questions new investors might ask is, “How can I use the money I have today to earn more money over time?” You’ll find the answer in a powerful concept called compounding. Here’s how it can work.
Principal is the amount of money you invest at the beginning of your journey. When you invest this money in a fund, after one year, you’ll earn a percentage in returns, adding to your bottom line.
It’s not much at first, but it sets in motion the compounding process—a big enough deal that Einstein called it the eighth wonder of the world.
Things get interesting when you add your year-end earnings to your principal, because now you’re starting out with a larger amount of money. If you reinvest this new and larger principal in the same fund, your earnings over the next year could be a percentage of a larger number.
And this is where the magic is, because if you repeat this process year after year, you’ll see that it can have a snowball effect.
Let’s plug in some numbers to see compounding in action. Say you start with $1,000—that’s your principal. You invest it in a stock fund with a 12% average annual return. At the end of the first year, you’ve earned $120—not bad!
Add that to your original amount, and now you have $1,120 you can reinvest in the same fund. Now that same 12% annual return will net you $134.40 by the end of the second year.
Add it to your total—and on and on for as many years as you want to stay invested. By the end of 30 years, your original $1,000 will have grown to $29,959.92!
And that’s how you can make money from money you already have. It takes patience and discipline to continue to reinvest your returns, but it can be well worth it. That’s the magic of compounding. To learn more about compounding, visit us at vanguard.com/compounding.
All investing is subject to risk, including the possible loss of the money you invest.
There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
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