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With the current economic uncertainty many people are worried about paying for their retirement. Social Security and Pensions are becoming less of a certainty than they once were, and most of the burden is being shifted to the individual in the form of 401k plans and IRAs. As daunting as the prospect of saving for retirement that could last more than thirty year can be, you have a major advantage on your side. That advantage is the power of compounding stock returns.

The power of compounding stock returns occurs over long periods of time; call it a get-rich slow strategy. Such a strategy rejects chasing after the latest financial fad, instead deciding to make investments that slowly but surely increase in value. You add to these investments regularly, such as by investing the same amount every quarter or using a 401k to invest with each paycheck, and reinvest dividend and capital gains income (thus adding to your principal).

Beginning a savings program at a young age is even more important for people who want to take advantage of compounding stock returns. Let’s consider the case of two 19-year-olds, Bob and Ted. Bob has a good job and starts putting $2000 per year into savings starting at age 19. Ted, on the other hand, decides to sow some wild oats and put off saving until he’s 27. Assuming that Bob makes an annual return of 10% on his investment, by age 26 he will already have saved a whopping $25,159 before Ted even gets his act together

The power of compounding stock returns from a young age can be illustrated by the following scenario: Let’s go back to our friends, Bob and Ted. Just when Ted is starting to save $2000 a year, Bob is laid off and stops investing. Even though Ted invests at this rate until retirement and Bob never invests another dime, Bob will have more money at age 65 than Ted. Bob, who invested $16,000 over a 7 year period, will have a total investment of $1,035,161. Ted, on the other hand, who started investing later and paid in $78,000 over 39 years will only realize $883,185. Clearly it’s better to start saving early in life.

The key to understanding how this is possible is that at age 26, our first person will actually earn more on his investments than he or his counterpart will add to their portfolios. He will continue to make money every year on these investments. Despite continued investing the second person will never catch up.

It is important to reiterate that all investment income is reinvested. Neither principle nor income is ever spent.

With Pensions and Social Security becoming a less feasible way to support oneself upon retirement, many are looking at alternative retirement accounts as a way to make money through times of economic uncertainty. While individuals are left to sift thru many options for retirement accounts, like Individual Retirement Accounts (IRA) and 401k plans, many are now looking at the power of compounding stock returns. Put simply, the power of compounding returns could be described as a get-rich slow strategy. Rather than chasing performance and increasing risk in the form of the latest investment fad, you add regularly to your diversified investments and reinvest any income your investments produce.

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