“Compound Interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” – Albert Einstein
Einstein’s quote speaks to how powerful years of compounded returns can be. Compound interest is unlike simple interest because you’re earning interest on interest over time. This creates a snowball effect as your money multiplies on itself. We often preach, “It’s not what you make, it’s what you keep”. Simply put- sooner you can start investing, the better off you’ll be.
An easy to way to understand compound interest is through the Rule of 72. This rule calculates how long your money will take to double given an annual rate of return. According to historical records (since 1926), the average annual rate of return for the S&P 500 is about 10%. Using 10% in the Rule of 72, your money would double every 7.2 years (72/10) all things being equal.
“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffet
We often tell clients it’s not about timing the market but the length of time you are in the market. For those just starting out, it’s critical to create a plan to start investing. Even just saving $100 a month can equate to hundreds of thousands of dollars years down the road. By saving consistently from month to month, you can use dollar-cost averaging to build your wealth over time. Dollar-cost averaging is investing a predetermined amount of money on a recurring, automatic timer (weekly, monthly, bi-monthly, etc.), regardless of current market conditions. This strategy helps investors smooth out the volatility (fluctuations) in a portfolio because people invest during both high and low points of a stock market cycle.
This chart (From thecalculatorsite.com) shows how an investment of $1,000 can grow to over $7,000 by earning 10% for 20 years. See the difference in simple interest (no compounding in blue) versus compounding (purple)?
To show the importance of saving early, let’s analyze two investors, John (Blue) and Bob (Orange):
- John decides to save $1,000 a year starting at age 20 and will stop contributing when he turns 40. This totals $20,000 in contributions over 20 years.
- Bob decides to wait until he’s 40 years old to start saving. Because he’s playing catch up, he decides to save $2,000 a year until he turns 60. This totals $40,000 in contributions over 20 years.
For this example, we are assuming a 10% average return every year.
When John and Bob turn 60, John’s portfolio is worth $423,849 and Bob’s portfolio is worth $126,005. John saved $20,000 less than Bob, yet his portfolio is worth $297,844 more than Bob’s. Why? John benefited from 40 years of compounded returns in the market, compared to Bob’s 20!
Compound interest is a significant factor when it comes to growing wealth. It’s not rocket science, but takes patience and discipline in order to work!
Please contact us if you have any questions!
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