Compound interest refers to the phenomenon in which the interest associated with an investment increases exponentially—rather than linearly—over time since the periodic gains on the investment increase the size of the principal that is the basis for the total return (dividends and capital gains).
The term compound interest can be confusing and misleading, especially in view of the current historically low interest rates. The word interest as it used here refers to gains on investment, not interest on the funds invested. Compound interest refers to the gains on your investment as well as the gains on those gains over the period the funds are invested.
Here’s an example. Let’s assume we begin with an account of $1,000,000 with a total return of 10% a year. If that total return of 10% (or $100,000) is withdrawn each year, the total return over time is nothing more than $100,000 times the number of years the funds are invested. This is a linear increase.
If the funds are not withdrawn, the absolute total return increases each year since the principal grows each year. So the $1,000,000 in Year One becomes $1,100,000 in Year Two and the total return for that year becomes $110,000 . . . and so on. This is an exponential increase.
As time passes, the difference is magnified considerably. Using a 20-year time horizon, if the total return approximates 10% a year and is withdrawn annually, the value of the original investment will be about triple. By leaving the gains in place, however, the value of the original investment will be more than seven times the original investment.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
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