The key is the power of compounding, the snowball effect that happens when your earnings generate even more earnings. You receive interest not only on your original investments, but also on any interest, dividends, and capital gains that accumulate—so your money can grow faster and faster as the years roll on. This is particularly evident in retirement accounts, where principal is allowed to grow for years tax-deferred or even tax-free.
Let’s say you begin with two separate $10,000 investments that each earn 6% a year (keep in mind this is a hypothetical example, and actual returns would likely be different and a lot less predictable). In one $10,000 investment, you withdraw your investment earnings in cash each year, and the value of your account stays steady, as you see with the flat line in the chart below. In the other investment, you don’t cash out your earnings—they get reinvested. The curved line below shows the power of compounding and time. If you keep reinvesting the earnings (and again, we’re assuming a steady hypothetical return of 6% each year) after 20 years your investment will have grown by more than $20,500. And if you’ve got an even longer time frame—for example, if you’re in your 20s and saving for retirement—after 40 years, your investment will have grown by more than $92,000.
This hypothetical example assumes two initial 10,000 investments that each earn 6% ($600) annually. The flat lower line shows the investment value when those earnings are withdrawn each year. The curved upper line shows the value when earnings are reinvested annually. As the reinvested earnings generate their own annual returns at 6%, the accumulated value accelerates toward the end of the 20-year and 40-year periods. The expense ratio assumed in this example is 0.23%. Taxes are not included in the calculations. This hypothetical example does not represent returns on any particular investments.
All investments are subject to risk