Beyond Passive Income: Compounding Is What Really Creates Wealth | Smart Change: Personal Finances

(Robin Hartill, CFP®)

Many people invest because they want passive income. After all, who doesn’t want to earn money doing nothing? But if you use your investments to generate income early on, you could be missing out on the chance to build up significant wealth.

If you forego passive income and reinvest your earnings, you can tap into the magic of compounding. Read on to learn how compounding can turn small amounts of money into a substantial nest egg over time.

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Passive income vs compounding

Passive income is money you earn with little or no regular effort. There are countless ways to generate passive income. For example, you can write a bestselling book and watch those royalty checks roll in, or you can buy rental properties, although either example requires a lot of time or money up front.

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Another way to earn passive income is through investing. Technically, in investing, passive income refers to the income generated by the investment, such as stock dividends or bond coupon payments, that you earn if you don’t sell the investment. But you can earn both passive income and capital gains by investing in the stock market.

If you want to get rich from stocks, you won’t want to use that money for income right away. Instead, you would reinvest your money to generate compound returns. Essentially, the money you make makes even more money. Over long periods, your money can grow exponentially.

Here is an example of how composition works. Suppose you invest $10,000 in a S&P500 index fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO). Your money earns 10% each year through capital gains and dividends, which is just around the historical average of the index.

Instead of withdrawing the $1,000 your money made in the first year, you leave it where it is. At the end of the first year, you have $11,000, which might not sound too impressive. But capitalization needs time to work its magic.

Suppose you never add a penny to your principal of $10,000. But year after year, you reinvest your earnings by 10%. Here’s how much you’d have – all thanks to compounding:

  • After 10 years: $25,937
  • After 20 years: $67,275
  • After 30 years: $174,494

How composition works in the real world

Most people don’t throw $10,000 on the stock market and never invest again. Instead, you can practice dollar cost averaging by investing smaller amounts each month in your 401(k) or Individual Retirement Account (IRA). Consistent investments combined with compounding income will propel your returns even further.

Imagine you invest $10,000 in the same S&P 500 index fund that has generated annual returns of 10%, only you decide to invest $100 per month on top of that and then reinvest that income as well. Here’s how your initial investment of $10,000, plus that extra $100 per month, would grow:

  • After 10 years: $45,062
  • After 20 years: $136,005
  • After 30 years: $371,886

As you can see, compounding is more powerful over long periods of time. There’s no denying that the later you start investing, the less time your money has to grow. This means that you either have to invest more or settle for a small nest egg. Or you may need to retire later to give your money enough time to grow.

When should you use investments to generate income?

If you’re like most people, the goal of investing is to grow your money so you can spend it someday. But it’s generally best to let your money grow until you need the income or reach the age at which required minimum distributions (RMDs) begin for your retirement accounts.

The power of compounding may not impress you if you only think in the short term. But long-term investing is what creates wealth. So relax and let those compound returns skyrocket your investment portfolio.

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Robin Hartill, CFP® has no position in the stocks mentioned. The Motley Fool has positions and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

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