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Cramer explains the magic of compounding

Key Points
  • "Mad Money" host Jim Cramer gives investors a lesson in compounding.
  • Compounding helps investors maximize their gains, he says.
  • The "Mad Money" host dubs the effects of compounding "magical."
VIDEO0:5000:50
How compounding can double your money

Unless you are born with a silver spoon in your mouth, accruing wealth doesn't come easily, which is why CNBC's Jim Cramer is so passionate about helping investors find a viable financial strategy.

"Thanks to the magic of compounding, the earlier in your life you start investing in the market, the bigger your long-term gains can be," the "Mad Money" host said.

Cramer is confident that even without a high-paying job, an investor can save a decent chunk of his paycheck and invest it wisely each year to grow his wealth.

In fact, when the "Mad Money" host researched the S&P 500 dating back to 1928, the average annual return through the end of 2014 was about 10%, including dividends.

"Show me an asset class with a better average return. You can't do it! Stocks aren't just the best game in town, they are really the only game in town if your goal is to grow your wealth," Cramer said.

The 10% average return on the S&P 500 may not seem impressive at first, despite the fact that it is more than double what one can expect from a 30-year Treasury bond and much more than what a certificate of deposit from a bank pays.

But with the magic of compounding, the potential long-term gain is impressive. For instance, if $100 is invested in the S&P 500 and it gains 10% in a year, that holding will be worth $110 by year's end. After another year and another 10% gain, it's worth $121. After a third year, it's $133.

The gains will continue to grow, because each year money is made from the previous year's profits. With that 10% average annual return, an investor can double his money in about seven years, Cramer said.

"The magic of compounding works best the younger you are because that means you have more time for your money to grow," Cramer said.

For instance, if a 22-year-old is just entering the workforce, she has more than 40 years before she retires. She can invest $10,000 in an S&P index fund right now with the anticipation that the next 40 years will not be too different from the last 40 years.

In that case, if the average return remains at 10%, in 40 years that $10,000 investment will be worth more than $450,000. Making that money did not require any stock picking, trading or even research on individual companies.

"All you have to do after you initially save that money is let it sit on the sidelines, ideally in a 401(k) plan or an [Individual Retirement Account] so that you don't' have to pay capital gains or dividend taxes on your gains," Cramer said.

The same logic can be applied to those in different age groups, but the "Mad Money" host insists that it is best to start early and get the biggest bang for your buck.

WATCH: Cramer breaks down compounding

VIDEO11:4011:40
Cramer: How compounding can help you double your money in 7 years

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