Albert Einstein has often been credited with saying that “compound interest is the eighth wonder of the world”. While it’s been disputed whether or not he ever said that, compound interest may actually be worthy of this declaration.
Most of us have probably learned about compound interest at some point in our lives, but seeing practical examples of it in action can be really motivating. For me personally, when I started reading more about investing and seeing concrete examples of how compound interest works over time, it got me really fired up to start saving and investing as much as I could and as early as I could.
For the majority of investors, one of the most important factors in determining how much you’ll be able to grow your investments will be the amount of time your money is in the market, and NOT whether you picked the best performing stocks or mutual funds or whether you used market timing to buy and sell investments at the most opportune times.
The basic premise of compound interest is that you start out with an initial sum of money (typically referred to as the principal sum), your principal then earns some interest, and then you begin earning interest on the interest. As time goes on, you’re continuously earning interest on the initial investment plus you’re earning interest on your interest and on your interest’s interest, and so on. The longer your money is invested, the more compounding will work and this will have a snowball effect, making your initial pile of money into a bigger and bigger pile of money.
Let’s look at an example of how compound interest works its magic for those that invest early. Suppose there are two young people, Señorita Saver and Señorita Spender, who have just started their careers at the same company and their starting salaries are both $55,000 per year.
Señorita Saver knows the importance of saving and investing and she wants to eventually have the freedom to stop working for money and do something like volunteer her time to local organizations, spend time with family, or travel the world. She immediately enrolls in her company’s retirement plan and contributes 10% of her salary for a total of $5,500 per year. In addition to this, she also decides to save even more on her own and contributes $5,500 per year to her IRA plan, for a total of $11,000 per year invested.
Señorita Saver continues to contribute exactly $11,000 per year for the next 15 years and her investments earn 7% each year. This gives her a balance of $276,419.24 after 15 years.
At this point in her career, she decides to do something she’s more passionate about and takes a pay cut to work for a non-profit. She stops making retirement contributions for the next 25 years of her career but also doesn’t touch her retirement accounts and they continue to earn 7% per year. At the end of her 40-year working career she has contributed $165,000 to her retirement accounts and they have grown to a value of just over $1.5 million dollars ($1,500,246.82).
Señorita Spender loves shopping for all of the finest things, going out to eat every day, and figures she doesn’t need to start thinking about saving for retirement until she’s much older.
For the first 15 years of her career, Señorita Spender doesn’t contribute a penny to any retirement plans. At the age of 40 she realizes that she needs to start aggressively saving or else she will be working forever (or eating cat food in her retirement).
Señorita Spender starts saving $20,000 per year in her retirement accounts and continues to do so for the next 25 years until she decides to retire at the age of 65. Like Señorita Saver, Señorita Spender’s investments earn 7% per year. At the end of her 40-year working career she has contributed $500,000 (more than 3 times the amount that Señorita Saver contributed) and her investments have grown to a total of $1,264,980.75.
Señorita Saver invested early in her career and then left her investments alone to grow during the remainder of her career. She contributed $165,000 in total and ended up with a balance of right around $1.5 million ($1,500,246.82).
Señorita Spender did not invest at all for the first 15 years of her career but then invested aggressively for the next 25 years. She contributed more than 3 times as much as Señorita Saver ($500,000 in total) but still ended up with ~16% less, at $1,264.980.75 vs. $1,500,246.82. In addition, she had to contribute almost twice as much per year ($20K/year vs. $11K/year) and for a longer period of time.
The example above really illustrates how important it is to invest as early as possible and allow compounding to work its magic. The more you’re able to invest in those early years of your career, the more options you’ll have later on. While Señorita Saver decided to still work 40 years in this example, she spent the last 25 of those years in a job that she was more passionate about because she could afford to save less going forward. She could have instead decided that she wanted to retire earlier, depending on when her investments grew large enough to support her annual spending for retirement.
Meanwhile, Señorita Spender had to work even harder and make more sacrifices later in her career in order to try and catch up. After 40 years of working, if the $1.26 million she saved up was still not enough to support her retirement, she would have to continue working more years until her investments reached the amount required to support her lifestyle.
This example stresses the impact that the amount of time your money is in the market has on its growth but the other part of the equation is the earnings rate. If your investments earn even a small percentage more each year, the effect of compounding is even greater. Had Señorita Saver earned 8% instead of 7% per year, the value of her investments would have grown to over $2 million ($2,045,456.37). That’s a 37% increase over the same time period just by earning an additional 1% per year.
While we have no control over what the market does each year, we can control some things like the amount we pay in expenses for our investments. As you learned in Why you Should Invest in Index Funds, avoiding unnecessary expenses by using low cost index funds allows you to take advantage of compounding even more as you’ll be maximizing the amount of market returns that you capture year after year.
To truly take advantage of compounding to grow your wealth, the key is to invest early and invest often and then stay invested for the long haul. Don’t panic and sell when the market dips (and it will dip!). If you’re jumping into and out of the market based on price fluctuations, chances are that you’re buying high and selling low…exactly the opposite of what you want to be doing. Studies consistently show that the returns of individual investors underperform the investments they’re invested in each year for this very reason. By being out of the market for just a few of the best days of the year, your returns can significantly lag behind market returns.
If you’re not contributing to your retirement plan at work or to an IRA, start as soon as possible. If your employer matches some percentage of your contributions and you’re not contributing, you’re losing out on free money so stop reading this now and go enroll! If you’re holding onto cash but scared to get into the market all at once, then use dollar-cost averaging to invest a fixed amount each month for the next 9-12 months (though the majority of the time you’re better off to invest it as a lump sum at the beginning).
Buy and hold!
Note: The examples used in this post are a bit extreme, though this was done on purpose to illustrate the point. Most people don’t invest everything early on and then stop investing or vice versa. Also, the market doesn’t consistently return the same amount each year. Rather, there are years with gains (both big and small) and losses (also both big and small). I also didn’t account for inflation. As the years go on, people generally tend to start earning more and thus are able to save more per year. For simplicity, the calculations above are compounded on an annual basis. Depending on the investment, compounding may be quarterly, monthly, etc.