TL; DR Invest early and invest often
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it”. This well-known quote from Albert Einstein is one of the most repeated quotes in all of personal finances and investing. And for good reason as it articulates a very important truth about time in the market! But what exactly is compound interest and how does it apply to the average person? More to the point, let’s discuss why compounding interest is truly a world wonder particularly when you are young.
The definition of compounding interest is fairly straightforward. The term refers to the benefit of receiving interest on your interest. Of course, depending on which side of the transaction you are on it could also be a detriment (think your mortgage payments). This idea can also be applied to your investment account returns. When investing for the long term, you receive the benefit of compounding returns on your gains. To illustrate this point, let’s consider an example. Suppose someone came to you and said, “I can give you $500,000 to spend on retirement 20 years from now.” Sounds pretty great right? But what if that same person, then offered to give you $250,000 at an interest rate of 7% for 20 years? Which of those options would you choose?
A 7% interest rate does not sound like a lot and it is actually about 3% lower than the all-time annual average of the broader stock market (as measured by the S&P 500 Index). So, it may come as a surprise that the second option would actually yield you almost twice as much money ($967,421.12 to be exact). To take this example a step further, what if instead of taking a 7% interest rate you invested $250,000 in an index fund that tracked the S&P 500? Assuming that the index returned its all time average of 9.56% (a pretty big assumption but we will roll with it for the sake of example) your ending balance in 20 years would be over $1.5 million!
As you can see, compounding interest or returns is a truly powerful phenomenon and the “eighth wonder of the world”. However, you may have noticed that in my example I used a fairly long time period, 20 years, to illustrate the benefits of compounding interest. That was not by mistake. As I mentioned before, compound interest is one of the primary arguments in favor of time in the market as opposed to timing the markets. Let’s consider another example. Suppose a 20yr old decided to begin investing $250/month and managed to average a 7% annual return. In 10 years, that individual would have invested $30,000 and would have gained about $13,271 for a total of $43,271 in 10 years. Now, let’s assume that the individual stops making their monthly contributions at age 30. Assuming that they continue to average a 7% rate of return until retirement (not out of the question) they would have almost $500,000 at age 65!
Now let’s consider a different individual. This individual gets a later start and doesn’t begin investing until age 30. Like the first example, they decide to invest $250 month (again assuming a 7% return) however, they do not stop investing after 10 years. Instead, they invest $250 every month right up until retirement for the next 35 years. Over 35 years, that equates to investing $105,000. With that amount of investment, one might assume that the second individual would end up with a much higher balance. Unfortunately for investor #2, they would actually only end up with about $450,000 at age 65.
Not only would they have invested $75,000 more but they would also have $50,000 less to use in retirement! In fact, the second individual would actually have to invest about $117,600 over 35 years just to catch up to the first individual! The charts below show the growth of the investments in both scenarios from age 30 – 65:
Table 1 https://www.gigacalculator.com/calculators/time-value-of-money-calculator.php
Table 2 https://www.gigacalculator.com/calculators/time-value-of-money-calculator.php
These two charts are hypothetical examples and are not representative of any specific investment. Your results may vary.
The moral of story here is that compounding interest is an incredible tool but is most advantageous when you take advantage of it early in your life. I don’t say this in order to discourage those who are getting starting later. Especially if they did not have the means to invest until later in life! However, I would encourage everyone, especially young adults, to get started with something. I used $250/month as an example but it doesn’t even have to be that much! As a matter of fact, we have several young clients who started their accounts with monthly investments of only $50. Which, for context, would still net you close to $200,000 at retirement (assuming the same returns) if you started when you were 20! So to summarize, if you are going to take advantage of compounding returns, you should invest early and invest often!
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The song of the week is on my mind as we welcome the arrival of our son Dallas into the world. Enjoy!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.