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If you’re looking for something to do with your tax refund, you should consider investing. Depending on your current age, you can manage to turn a one-time investment into a respectable lump sum by the time you retire with very little effort. All you need is patience.
The power of compound interest
Albert Einstein is often credited with calling compound interest the “Eighth Wonder of the World,” and when you begin to understand how it works, you can see why. In investing, compound interest happens when the interest you earn on your investments begins to earn interest on itself, and it plays a vital role in generating wealth. With compound interest, one of the best things that can be on your side is time; the earlier you begin investing, the better because it allows for compound interest to work its magic.
Image source: Getty Images.
Let’s imagine you invest your $1,000 tax return into an index fund like those that track the S&P 500, which historically returns 10% annually in the long run. If the index fund you invested in had an expense ratio of 0.03%, here’s roughly how much you would have accumulated by the age of 67 at different starting ages:
Starting Age
Years Until 67
Annual Return (With Fees)
Amount Accumulated by 67
25
42
9.97%
$54,100
30
37
9.97%
$33,600
40
27
9.97%
$13,000
42
25
9.97%
$10,700
Data source: author calculations.
In this case, as long as you invest the $1,000 by age 42, you can expect to accumulate at least 10 times your investment by retirement age. And as the chart shows, the earlier you begin, the more you can multiply your investment without any additional work; time is doing the work for you.
The role dividends can play
Our above example assumes your investment doesn’t pay out dividends, but if it were to be invested into a dividend-paying asset, you could add to the effects of compound interest by reinvesting dividend payouts back into the asset. This is often referred to as a DRIP (dividend reinvestment plan).
Assuming your $1,000 investment had a modest 2.50% dividend yield, it would pay $25 annually. If you received the dividend in cash, you would have earned $750 in 30 years. If you reinvested that $25 annually into a fund generating 10% returns, the dividend alone would have accumulated to over $6,600.
Consider using dollar-cost averaging
Dollar-cost averaging involves making consistent investments at regular intervals. Not only can it help fight the urge of trying to time the market — something virtually impossible to do consistently in the long term — but it can also get you in the habit of making investing part of your routine. Instead of investing your $1,000 at once, you can use dollar-cost averaging and divide it into one of these intervals:
Weekly: $1,000 / 10 weeks = $100 weekly
Monthly: $1,000 / 5 months = $200 monthly
Quarterly: $1,000 / 4 quarters = $250 quarterly
Doing it this way can also hedge against a situation where you invest the whole $1,000 right before a drastic decrease in the investment’s stock price. And while the opposite can happen — investing right after a dramatic increase in its price — the goal should be to remove as many emotions from investing as possible.
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