by Archie M. Richards, Jr., CFP^®
August 15, 2005

Most people aren't aware of the power of compound earnings. Here's an illustration.

On your 26th birthday, you start investing $3,000 a year in an IRA, which gains at 10 percent a year.

On your 34th birthday, 8 years later, your contributions have totaled $24,000, and the account is worth $34,300. You then decide to move to Tahiti and paint pictures of sunsets and gorgeous women. You stop contributing to the IRA, but otherwise leave the account alone to continue compounding.

Thirty years later, when you're 65, the IRA is worth $598,000.

When your neighbor, Ralph, was 26, he didn't think he could afford $3,000 contributions to his IRA. (Actually, he could have afforded at least some contributions, but he's not as careful as you are about expenses.)

Eight years later, on his 34th birthday, Ralph starts his IRA. He then contributes $3,000 a year, year after year, for 30 years. The total invested comes to $90,000. Ralph's IRA also grows at 10 percent a year.

At age 65, it's worth only $493,000.

Big difference: You invested $24,000 in eight years and end up with $598,000. Ralph invested almost four times more for almost four times longer and ends up with $100,000 less.

The two IRAs gained at the same rate. The only difference was, Ralph had compound earnings working for him for 8 fewer years.

If you hadn't moved to Tahiti, but continued contributing $3,000 a year to your IRA until you reached 65, you'd have invested $114,000, and the IRA would have been worth $1,092,000 - almost $600,000 more than Ralph's IRA at 65.

These fantastic results are achieved just because you made your contributions for 8 years longer.

Compound earnings are powerful stuff. Albert Einstein, whose ideas made possible atomic power, was asked, "What is mankind's greatest development?"

"Compound interest," he said. (I use the term compound earnings instead, because you can't achieve 10 percent a year with just bonds. But you can, by investing mostly in stocks. Since 1926, stocks have gained by more than 10 percent a year. I believe they'll continue doing so.)

What's the key that unlocks these tremendous returns? You leave the money in the account for many years to compound - simple as that.

Take the first year, when you invested $3,000. The account earns 10 percent, or $300. At the beginning of the 2nd year, you add another $3,000.

Your two investments total $6,000. But the 10-percent earnings during the 2nd year are not $600. They're $630. You earn an extra $30, because you didn't withdraw the first year's earnings. Each year, your earnings are based on your contributions and on the earnings from previous years.

During the first 20 years, the earnings from previous years are small. But after 20 years - and especially after 30 years - the earnings from previous years become huge.

The key is, you have to leave the money in and adjust your spending so that the money stays invested.

Plus, you have to begin as soon as possible. This isn't easy, of course, if you're in your early-20s, holding a low-paying job, married, with a couple of kids, and mortgaged up to your nostrils. But as soon as you possibly can, get started investing. Start small if you have to, but start. You need at least 20 years and preferably 30 years of leaving the money in to benefit significantly from compound earnings.

The power of compounding means you don't have to fiddle around with your investments. The less fiddling, the better. Just get in. Use a reasonable variety of index funds or exchange-traded funds, rebalance every year-and-a-day (to avoid short-term capital gains), and otherwise let time and the market do the work.

Trade as little as possible. Give time and the market a chance. Let two or three decades of uninterrupted compounding provide you with fabulous fruits.

With the demand for home ownership high, the demand for renting is low, and rents are cheap. I don't expect housing values in most areas to decline much, if at all. But if you're starting out and can postpone home ownership, rent for a while. You'll save money.