The snowball effect - get the 'magic' of compounding working for you
Kick a small ball of snow into motion from the top of a hill and by the time it gets to the bottom, it will be HUGE. That's the snowball effect - and you can get the same growth effect in your investments thanks to the 'magic' of compounding.
Make even a small investment and leave that investment and the income it generates to be reinvested - or compounded - and over the longer term, your small investment will grow exponentially.
The key is to get your financial snowball rolling as soon as possible. The sooner you invest, the longer your money will have to grow. And that usually means more wealth at the end of the road.
Here is a simple example of the power of compounding:
- You invest $10,000 at 10%, and in a year you have earned $1,000 in interest.
- You add that to the original investment for a new total of $11,000, and the following year that new total earns $1,100 in interest at the same rate.
- Assuming there was no immediate tax on the interest, you now have a total of $12,100 invested at 10%.
When you add regular contributions inside a Registered Retirement Savings Plan (RRSP) to the power of compounding, the results can be more impressive. This is because the money you earn grows on a tax-deferred basis. Since you don't pay tax until funds are withdrawn from the RRSP, your yearly returns aren't reduced. Every cent you earn can be reinvested at its full value to earn even more money within the RRSP.
For example, if you were to make an annual $5,000 contribution to an RRSP at the end of each year, you could expect to have $861,584 after 35 years assuming an average 8% annual rate of return. Contribute the same amount at the beginning of each year and you'll have $930,511 on the same date - a difference of $68,927.
Not taking full advantage of your RRSP can make a significant difference in your investment. If you miss making the first $5,000 annual contribution and start the following January, you would lose $73,927 in retirement wealth at age 65, assuming an average annual return of 8%. If you have 20 years until retirement and you delay your contribution by one year, you'll be missing out on $23,305. Or, if retirement is just 10 years away, you'll give up $10,794 of earnings. This assumes you shorten your contribution period by one year.
A professional advisor can help you devise a plan to take advantage of the power of compounding -- and you'll be amazed at how quickly your investment snowball starts to grow.
This column, written and published by Investors Group Financial Services Inc. (in Quebec - a Financial Services Firm), presents general information only and is not a solicitation to buy or sell any investments. Contact a financial advisor for specific advice about your circumstances. For more information on this topic please contact your Investors Group Consultant.
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