Let's say you make a $100 investment in a fund that rises 20% in a year. After that year, you'd have $120. Instead of selling your shares, you let them ride, and the fund gains another 20% the next year, bringing your investment value up to $144. That's an additional $4 in gains over the first year (or 4% on the original $100 investment) generated because you gained 20% not only on your original investment but also 20% on all the gains earned in the first year.

While this may not seem like an impressive amount, with each passing year, that earnings potential grows even higher, so long as the investment prospers. If you start actively investing a set amount each year, adding to the amount generated by what the investment earns on its own, you create even larger potential earnings. Take a look at the table below to see what I mean.

An Example of Compounding in Action

I set up several different scenarios for the purpose of this table. All of them assume an 8% annual return, with the difference in scenarios being the amount contributed per year, increasing in $1,000 increments from $1,000 to $5,000 (the maximum currently allowed under IRS rules for investors age 49 and younger for 2008), from the age of 15 to 70. Yes, I realize that 2008 was a disaster, but remember that the long-run average for stocks is closer to 10%, and we certainly aren't done yet.

Finally, the last scenario attempts to show a conservative, natural progression a young person might follow as they age and gain employment — starting with their first summer job at age 15, they invest $1,000 a year until they graduate from college and get settled into a career, bumping their contribution up to $2,000 a year by 23. By age 30, they will (hopefully) be well-established and able to again bump their contribution up to $4,000, and at 40 a bump again to $5,000, an amount they continue to contribute up until retirement.

You can see that the greater the contribution and the greater the time that's passed, the larger and faster the account grows. That is the power of compounding — by constantly adding to your investment, you increase the potential return, going from what seems like a paltry $1,000 initial investment at age 15 to almost $420,000 by age 60, simply by adding $1,000 a year to the account and achieving an 8% annual return. With larger initial (and subsequent) investments, you get even more bang for your buck.

So the next question is: How can we get a teenager to save for retirement?