Time to Build Wealth

This is an updated version of a column originally run in 1999.

Conventional wisdom argues that you need a pile of cash before you may begin to invest successfully in stocks. Low-cost brokers and dividend reinvestment plans (DRPs) turn this notion on its head and prove the opposite can be true. Whether you have $100 or $100,000, what's most important is how soon in life you start to invest and where you invest. A Fool starting out with $100 can be in a better position to succeed than a Wise man with $100,000.

How can this be?

Because discipline, time, and compounding are the three main contributors to successful investing, not the amount of money you start with.

Discipline
An investor with a little money to start, the right discipline (which so many -- even a majority -- of us lack), and years to be invested (ideally a decade or longer) can use compounding to build a nest egg that rivals anyone's. The first necessary asset is discipline. Without the right discipline, many investors are their own worst enemies.

Enter: one great solution.

Dollar-cost averaging (through dividend reinvestment plans or on your own) provides a ready framework for successful investing. The discipline includes staying invested at all times, not actively trading, and -- for most investors -- consistently saving more money and buying more shares.

Dollar-cost averaging supports all three of these disciplines. You steadily buy more stock in the interest of asset accumulation, so it is rare that you make snap decisions when the market swings. Through investment plans or discount brokers, dollar-cost averaging is easy and cheap (free with many DRPs), which means you see dips as buying opportunities. Every month, you're socking away more money in stocks or index funds for long-term gain.

Time
The S&P 500 has risen 10.5% annualized since 1926, with nearly half the gain coming from reinvested dividends (which explains why the Fool recently launched its Income Investor newsletter). Compare 10.5% annualized to the low rates a 30-year bond or savings account pays you. The stock market has been the best-yielding investment over its history, yet millions of people have lost money in it. Why? Because it is largely time that awards gains.

As we all know, the stock market declines many years, but it is unpredictable, so trying to make forecasts is costly. Studies show a majority of the stock market's annual gains take place during a condensed period -- over a number of combined weeks in any given year. If an investor misses those weeks, her results suffer. An investor needs to stay invested -- and keep investing -- in leading companies, and history demonstrates the longer you're invested, the better.

When you couple the power of a good investment discipline with time, you get a one-two punch. Discipline combined with time results in your desired outcome: compounding.

Compounding
To compound your money is to build wealth on top of wealth, as well as on top of your original investment. If you start with $1,000 and you earn 10% in year one, you'll earn $100 and have $1,100. If you earn 10% again in year two, you'll earn $110, not just $100, because your investment base has grown. The following year, another 10% gain will represent an even larger dollar amount earned. Compounding is simple yet magical math.

Discipline + time = compounding
When you combine the three criteria necessary to build wealth, you get the equation that headlines this paragraph: discipline + time = compounding. In the end, compounding your dollars is the goal. Write the equation down (D+T=C) and tape it to your computer screen if you too actively watch and worry about stocks.

The following tables show how various compounding scenarios play out.

The first investor below began with $500 and added $100 monthly. The total amount invested at the end of 20 years was only $24,500. After 40 years: $48,500. The second investor (table two) invested only $1,000 to start and added $200 per month. Look how relatively modest sums of money compounds.

  Value when annually growing:     7%        11%        15%Year 1     $1,775    $1,820     $1,866 Year 5      7,868     8,816      9,911 Year 10    18,313    23,194     29,741 Year 15    33,120    48,052     71,528 Year 20    54,112    91,031    159,581 Year 30   126,055   293,806    736,098 Year 40   270,637   899,929  3,295,955 
  Value when annually  growing:     7%        11%         15% Year 1     $3,550     $3,640      $3,732 Year 5     15,736     17,632      19,822 Year 10    36,626     46,388      59,483 Year 15    66,241     96,105     143,057 Year 20   108,224    182,062     319,163 Year 30   252,110    587,612   1,472,196 Year 40   541,274  1,799,589   6,591,911 

There are two important lessons to take from these tables:

1. Time is the most necessary asset to successful investing.

2. Your annual return is crucial.

A 4% difference in your annual rate of return can make the difference between a $3.2 million portfolio and a $900,000 portfolio over 40 years. As for time, notice how most of the value is created in the later years.

That is how compounding works, especially when you buy a company at a good value that becomes more and more successful (imagine owning such household names as Wal-Mart (NYSE: WMT  ) , Microsoft (Nasdaq: MSFT  ) , or Intel (Nasdaq: INTC  ) over the last 10 years). Most of your wealth is created at the back end of an investment's life due to compounding. You need to let your money be invested long enough so that it can compound.

Have a great weekend.

Jeff Fischer is happy to see his colleague Selena Maranjian continue her work today to getteens investing. The earlier you begin, by far the better. If more young Americans could start to save and invest, prosperity would be much more widespread within a generation. Of stocks mentioned, Jeff owns shares of Intel in a Drip. The Fool has a disclosure policy.


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