There once was a man with a red paper clip who wanted to buy a house. He had no money. So one day he traded his paper clip for a pen shaped like a fish. Then he traded his pen for a hand-crafted doorknob. Weeks later he traded the doorknob for a camping stove. It sounds like a fairy tale, but the story is true , and the man did it all within just one year.
The story is the perfect illustration of the power of compounding: What starts small becomes big, because you're earning growth on top of more growth.
Compounding is important because it's critical in understanding the answer to a favorite question among investors: The simplest way to answer this question is with one easy math trick you can perform without even using a calculator. It's called "the rule of 72": Take your estimated annual return and divide by The resulting number represents the number of years it will take to see your investment double.
However, this rule assumes the rate of return will be unchanged over the years. This, in reality, is unlikely. Therefore, you should take special care to make reasonable assumptions about what return you can expect.
An in-depth study from researchers at Vanguard revealed some interesting facts about the predictability or unpredictability of market returns. In reviewing annualized returns of the stock market since , they drew several conclusions. First, they learned that "stock returns are essentially unpredictable at short horizons. How about predictability over the long term? Here's what they have to say: Put simply, nobody knows where the broad market is going to go, or why it went where it did.
With so much uncertainty, the lesson is clear: There's no way to make a quick buck on the stock market. Smart investors never make this their goal; instead, they play the long game.
They anticipate fluctuations in the market, and handle them by investing money they can afford to leave untouched for years. This is where the power of compounding and the red paper clip comes into play. It's only with a long-term horizon that you can weather the inevitable fluctuations of the market. You can take additional steps to manage the unpredictability of the market with strategies like dollar-cost averaging DCA.
You don't know if you're getting into a stock at a high or a low, because you don't know what's coming next. But you can enter the market at multiple times rather than all at once, by purchasing shares in installments. This means your average "basis," what you paid for your shares, smooths out the ups and downs, helping to avoid the problem of buying at a high only to see the lows follow.
Depending on market changes, lump-sum investing can outperform dollar-cost averaging. However, DCA might be a suitable approach if you're seeking to make automated, regular contributions to an investment account over the long term, especially if a lump sum is not available.
It would be wise to remember the adage "the long way is the shortcut. Keep the focus on the long term. The Motley Fool has a disclosure policy. Skip to main content The Motley Fool Fool. Stock Advisor Flagship service. Rule Breakers High-growth stocks. Income Investor Dividend stocks. Hidden Gems Small-cap stocks. Inside Value Undervalued stocks. View all Motley Fool Services. Learn How to Invest. Oct 1, at 2: It's a game of chess, not checkers.More...