Learning the magic of compounding

A high school economics teacher who was teaching the class to 12th graders for the first time this fall emailed me this question: What was the most important lesson he could teach his students about investing and economics?

To which I replied: the concept of compound interest.

After all, compound interest is the eighth wonder of the world — behind the pyramids of Egypt but far ahead of Astro Turf. Albert Einstein once called compound interest “the most powerful force in the universe.”

I chose compound interest because it is such a positive habit to develop, and it is the foundation for building wealth. Compounding’s basic premise is that savers earn interest on their interest, providing the trajectory to move forward financially.

Jamie Bosse, a Kansas City-area financial planner with Aspyr Wealth Partners, devotes several pages on the topic in her book “Money Boss Mom.”

I particularly like the way she simplifies the concept and slips in relevant examples.

“For teens, what is most powerful is that they have time on their side to grow their money over their lifetimes and careers.”

— Tina Hay, creator of the Napkin Finance financial education website

She said compounding means “one dollar invested today is worth more than one dollar invested in the future. Essentially, you earn interest on your initial deposit, and that interest also starts earning interest, so your savings grow much faster over time.”

The same principal applies to investment returns but on a grander scale, Bosse said. “If you leave your money and the returns you earn invested in the market, those returns are compounded over time in the same way that interest is compounded.”

Her message to teens: “The sooner you start compounding, the more magical it becomes.”

I also asked Tina Hay, the creator of the Napkin Finance financial education website, how she would define compounding to a young audience.

“For teens, what is most powerful is that they have time on their side to grow their money over their lifetimes and careers,” said Hay, the author of “Napkin Finance: Build Your Wealth in 30 Seconds or Less.”

As for how to turbocharge compounding, Hay said the three best ways are to have a “longer investment horizon, minimize fees and invest in securities (that offer) higher rates of return” than other investments. I might add one more: Shift more money to your savings and investments along the way.

Teens also need to understand that compounding won’t speed up the growth in your accounts if you withdraw your money instead of letting it continue to grow.

Hay made one other point: As many of you know, compounding can work against you if you have taken on credit card or other debt.

“When you accumulate debt, you will be paying interest on the amount you owe,” she said. “Compounding interest can significantly increase how much money you are required to pay over time. This can especially sneak up on people with large amounts of credit card debt.”

The takeaway from both personal finance experts? Make sure compounding is working for you rather than against you.