Compounding to Retirement

A lot of focus is placed on being responsible for your own retirement by setting aside money ever year consistently towards that goal. It is not enough to just set aside money but to also invest it. There are myriad investment options available and we need to choose one that fits you with your risk and return profile.

Take the case of Anne who has just begun her first job and has started to save some money. She invests the $16,500 she has saved in a liquid CD, earning her about a 2% interest. At the end of 10 years, this $16,500 would have grown to $20,113.41.

What would happen if Anne started to contribute to the 401K plan at her work rather than investing in a liquid CD? She can contribute a maximum of $16,500 for the year 2011 to her 401K. If she contributes the maximum of $16,500 and invests that in the mutual funds in her 401K, assuming the average rate of return is 8% per year, this $16,500 would grow to $35,622.26 in 10 years. She would be able to double her initial investment in 10 years.

What if she contributes a sum of $16,500 every year for 10 years with an 8% rate of return? At the end of 10 years, Anne would have $274,650.54 in her 401K account. This is much better than doubling your investment in the same time period. This is possible because of the compounding effect of your annual contributions. Not only did your contribution grow by 8% but also the earnings on the contribution grew by 8% every year and you are also making additional contributions every year, whose earnings are also growing at the same rate every year.

The rate of return on an investment plays a crucial role in determining the time period within which the investment more than doubles. A 2% rate of return will take more than 35 years to double the initial investment versus an 8% rate of return, whereby you can double your investment in 10 years.

The key is to choose an investment that returns the most for the level of risk that you are taking, thereby enabling you to grow your investments and in turn being able to fund your own retirement.