Unless you're independently wealthy, you should be saving and investing for retirement -- starting, ideally, in your 20s or 30s. Sure, if you're 47 and haven't really started yet, start now. But those who start early have the most to gain, and they don't even need to be socking away huge sums every year.

The retirement savings hack that has made the biggest impression on me is (drum roll...) compounding. Here's a look at how powerful compounding can be when you're trying to build wealth.

A firefighter is smiling in front of a fire truck.

Image source: Getty Images.

What is compounding?

You'll often see compounding referred to in relation to interest. So here's how that works: Imagine you have $1,000 in the bank and you're earning 5% interest on it. In the first year, you'll get $50, which is 5% of $1,000. That $50 is added to your $1,000, becoming $1,050. In year two, you'll get 5% of that $1,050 instead of 5% of $1,000 -- so $52.50 is added to your account, for a total of $1,102.50. Year three, and 5% of $1,102.50 is $55.13.

See what's happening? Your account's value is growing over time, and the amount by which it grows each year is also growing. That growth is compounding.

When you invest in stocks, you can also benefit from compounded growth. Consider that the overall stock market has averaged annual gains of close to 10% over many decades. If you invest in a simple broad-market index fund, such as one that tracks the S&P 500, you might enjoy an average annual return of 8%, 10%, 12%, or some other rate. Here's how your money might grow over time at 8%:

Growing at 8% For:

$7,500 Invested Annually

$15,000 Invested Annually

5 years

$47,519

$95,039

10 years

$117,341

$234,682

15 years

$219,932

$439,864

20 years

$370,672

$741,344

25 years

$592,158

$1,184,316

30 years

$917,594

$1,835,188

35 years

$1,395,766

$2,791,532

40 years

$2,098,358

$4,196,716

Data source: author.

How to build wealth through compounding

Clearly, whether you're aiming for a retirement nest egg of $1 million, $2 million, or more, you might get there through the phenomenon of compounded growth. You need three things for that:

Time

The table above shows hefty sums being amassed, but the heftiest sums are at the bottom of the table -- because compounding is most powerful when it has a lot of time in which to work. You money in the examples above grows by tens of thousands of dollars annually in the early years and then by hundreds of thousands of dollars and even millions later on. This is why it's so powerful to start saving and investing early.

Money

The table above has two columns, and you can clearly see how much more you might amass if you're socking away big sums each year. So try to sock away big sums each year. And don't put off doing so, because your earliest invested dollars are your most powerful ones, as they have the most time in which to grow.

Growth rate

Finally, your money should be growing at a good clip. Adding money to your mattress won't result in much growth over time. It's hard to beat the stock market for long-term wealth-building, but the stock market offers no guaranteed growth rates. Over long periods, it has always gone up, though, usually while outperforming bonds and other alternatives.

So put those three factors together and you have a winning strategy:

Aim to invest meaningful sums in the stock market regularly, for a long time.

Investing in stocks

Here are some solid low-fee index funds to consider:

ETF

Expense Ratio

5-Year Avg. Annual Return

10-Year Avg. Annual Return

15-Year Avg. Annual Return

Vanguard S&P 500 ETF (VOO) (VOO 1.29%)

0.03%

14.78%

13.08%

14.90%*

Vanguard Total Stock Market ETF (VTI 1.31%)

0.35%

14.09%

12.52%

13.50%

Vanguard Total World Stock ETF (VT 1.03%)

0.09%

10.16%

9.28%

9.37%

Data source: Morningstar.com, as of Dec. 27, 2024, and Vanguard.com.
*Since inception, Sept. 7, 2010.

Here's a bit about each:

  • Vanguard S&P 500 ETF: S&P 500 index funds are focused on 500 of the biggest companies in America, which together make up around 80% of the entire U.S. market.
  • Vanguard Total Stock Market ETF: This ETF aims to include all U.S. stocks, including small and medium-sized ones.
  • Vanguard Total World Stock ETF: This ETF encompasses just about all the stocks in the world.

These funds can be all you need to build a secure financial future for yourself.

If you want to aim for faster growth, you might park some of your money in more aggressive ETFs -- or in some individual growth stocks. To do so, it's best to read up more on investing, so that you understand any risk-return trade-offs you're making.

And remember that you don't need fast-growing stocks and funds if you have enough time. If you're socking away many thousands of dollars a year and you have plenty of years ahead of you, you can grow quite rich without taking on that much risk. Remain diligent, and an 8% or 10% growth rate can build your wealth quite effectively -- through compounding.