COMPOUNDING PROVIDES BETTER ODDS THAN THE LOTTERY

Three in ten Americans think their best chance to end up with at least half a million dollars in their lifetime is to win a lottery or sweepstakes, according to a recent poll by the Consumer Federation of America. With the odds of winning a lottery at one in 10 to 20 million, they're 10 to 20 times more likely to drown in their own bathtubs, according to figures from the National Safety Council.[ National Safety Council: http://nsc.org/lrs/statinfo/odds.htm]

Many people don't realize that they can dramatically increase their odds of accumulating half a million dollars through something far less visible, but far more powerful, than a lottery: compounding.

Here's a question the Consumer Federation of America asked the people it polled: If you invested $25 a week for 40 years, and earned a modest seven percent on that money, how much would you have at the end of 40 years? Did you guess over $150,000? Only one-third guessed that high. The answer: $286,640. Double that $286,640 by investing $50 a week and you pass the half million dollar mark.

Why is compounding so powerful? The concept is simple. Compounding is when you earn money not only on the money you put into a savings account or an investment, but on the earnings themselves. Say you put $100 into a money market account earning five percent. At the end of one year, you have $105 (the total would be a little higher if the account is compounded daily or weekly). The next year you earn five percent on the $105, not just the original $100. The account finishes year two with $110.25. At the end of ten years, the account will have grown to $163 without you ever kicking in another dime of your own (taxes are not figured in here).

As the example shows, it takes a while for compounding to get up a head of steam. That's why people often overlook its power, and how small contributions can grow to large amounts.

This illustrates not only the power of compounding, but the devastating cost of delay. Say you don't put any money in the first seven years. In the eighth year, you put in $2,000 and every year after that. It would take you 20 years of annual $2,000 contributions before the total amount in the IRA would equal the amount in the IRA that stopped contributions after only seven years.

The power of compounding is magnified by higher returns. Say you put $100 a month into a money market earning five percent. At the end of 40 years, you'll have $153,238 (again, not counting taxes). Invest $100 in an IRA earning eight percent and the account will reach $351,428. That's more than double the earnings at five percent, even though the average rate of return did not double.

Compounding works best if you leave the money alone. American investors tend to be "fidgety." The Boston-based financial research firm of DALBAR found that investors who bought and held the same stock mutual funds over the past 15 years earned an annual average of 17.9 percent. But DALBAR found that investors moved in and out of their stock mutual funds every three years on average. They earned an annual average return of only 7.25 percent. If these investors were putting in $100 tax-deferred a month in these funds, the investors who held on for 15 years would have earned roughly $57,000 more than the investors who changed funds every three years over the same period!

Many people who pin their dreams on winning the lottery probably feel they don't have money to invest. Yet it's not uncommon for aggressive lottery players to spend $25 or more a week attempting to hit the jackpot. They just don't realize they could make a better bet letting that $25 compound.