Intro to Compound Interest
Like it or not, I’m going to throw a little math at you. I know many cringe at the thought of math, but one of the most important concepts about wealth you will ever learn involves some numbers, so bear with me! The concept I’m going to talk about is Compound Interest. And oh, baby, what a powerful tool this concept is!
Albert Einstein called compound interest the “greatest mathematical discovery of all time,” dubbing it the 8th Wonder of the World. Unlike most mathematical concepts we learned in high school (let’s be honest, will you ever be using trigonometry?), compound interest is an everyday truth that can and should be understood and used by all of us. Surprisingly, however, compound interest remains an utterly mysterious, little known, pitifully understood concept for common society.
But, as you might have guessed, the wealthy DO understand this concept.
The wealthy and financially savvy utilize compound interest as their tool to ensuring slow and steady growth in their investment portfolios, charitable foundations, bequests, and endowments. I believe that the knowledge, understanding, and practice of this concept, are the main reasons why the wealthy tend to stay wealthy, and the middle class and poor tend to stay middle class and poor.
The wealthy knowingly use compound interest to their advantage while the middle class and poor unknowingly let it keep them from ever improving their financial well-being.
The wealthy educate their own children on the power of of compound interest and lead by example in their daily lives. Their wealth grows over the years before it is passed down to the next generation, who in turn, perpetuate the practice. The poor and middle class, on the other hand, either don’t know/understand or choose not to implement the concept day to day. As a result their wealth does not grow to its full potential. Their children, left with neither their parents’ monetary means nor the understanding to grow their own financial future are forced to perpetuate the vicious cycle.
So break the cycle! Learn, understand, and put into practice compound interest today and everyday!
Your Rich Uncle Milton and his $100k Gift
First, however, let’s move a step back here. Take a second and close your eyes…try to remember sitting in your high school math class. Like all American teenagers, you were undoubtedly instructed at some point on the concept of exponential growth. You know, you take a number and raise it to the nth power. Unbeknownst to you at the time, this little lesson is the brainchild of the mathematical phenomenon of compound interest. It works like this:
Let’s say you’ve just graduated college and you’re 22 years old. Your rich uncle, Milton, gives you $100,000 as a graduation gift (don’t we all wish we had a rich uncle like that). You smartly decide that you should take action immediately.
You decide to pay a visit to your local Scottrade branch, where you open an investment account, choosing to invest your money in an index fund such as the iShares Russell 2000 Value ETF. Once the $100,000 is invested, you leave it there untouched for the next 45 years (you want it for retirement when you’re 67). Since the fund invests in a plethora of small cap, value-oriented stocks that tend to perform very well over the long-term, you earn 10% on an annual basis (the average return over the past 20 years ended December 31, 2013 was 10.6%, so I think 10% is a fair assumption for our purposes).Aside: Obviously, the return won’t be 10% every year, as there will be big up years and big down years. Over the past 20 years alone, we’ve had two very major market sell-offs where all stocks were down big. One year might be down 10%, the next up by 20% and so on. As history shows, however, the general direction is up over the very long term…way up! Not being invested during the times the market runs upward is much more damaging long term than being invested when the market falls. That’s why a disciplined “set it and forget it” mindset must be followed when investing long term. Most importantly, never panic!
So bear with me, here’s the math equation: FV=PV*(1+r)n
PV= Present Value ($100,000 in this case)
r= Rate of Return (we’re assuming 10%)
n=Time Period (45 years in our case)
FV=Future Value (in this case, the value of your investment when you’re 67)
So plugging it all in and solving for FV, FV=$100,000*(1.10)45 or $7,289,045.
As you see, with time, compound interest will work its magic, turning $100,000 into well over $7 million during the 45 year period.
As you’re probably figured out by now, this is true because each year’s interest earned on the original $100,000 is added to the base amount, and then the whole amount is grown again and again by 10%. Interest is earned on interest.
Here’s a quick table so you can visualize the growth by year. I’ve skipped years 11 through 42 to save space.
Compound Interest and Time Go Together like Peas and Carrots
Time is compound interest’s best friend. Although growth seems slow at the outset, each subsequent year money is left untouched to grow at the rate of return, the amount of monetary growth accelerates at a faster and faster pace. The more years you have, the greater the effect of compound interest.
For this reason, many wealthy parents start college funds and even retirement funds for their children while they are very young, or even newly born. Imagine the growth over a person’s entire life, say 90 years. Let’s say $10k (more reasonable than $100k) is put aside for your child at birth and earns the same 10% interest over his/her 90 year lifetime. At age 90, this $10k would be over $53 million!
Better still, imagine the growth if the money were left untouched for two generations, let’s say a total of 150 years. Our $10k example would be worth over $16 billion!! This is what we refer to as generational wealth – the reason rich families tend to stay rich or grow richer.
Although these assumptions do not take into consideration the cost of inflation, they serve to give you a broad understanding of what compound interest can actually achieve. These aren’t fuzzy numbers, people, this is the real deal!
Why Start Now?
To prove another very important point, I want to mention the cost of waiting to invest, let’s say that rather than investing Uncle Milton’s gift (we’re back to the $100,000 example) right away at age 22, you forgo the opportunity out of laziness, lack of knowledge, or general indifference. You finally get around to investing the money 10 years later when you are 32 years old. Now, however, you only have 35 years until you retire at 67. Running the math that we discussed earlier using 35 years instead of 45 years, you’d have $2,810,244 at age 67, no small sum at first glace.
However, compared investing right away at 22 and having 45 full years of compound interest, you are now $7,289,045 – $2,810,244 = $4,478,802 poorer at age 67.
I want to emphasize this important point. Waiting, delaying, failing to act or strike while the iron is hot, makes you poorer than you otherwise would have been…$4.5 million poorer in this case! And that’s a lot of quiche!
How Does this Affect My Daily Spending Habits?
So armed with that knowledge, now think about your daily level of spending. Think about the items you choose to buy. Every time you use money to buy something, you are forgoing the opportunity for that money to be invested and earn compound interest. That expensive purse, hunting rifle, set of golf clubs or new car isn’t just costing you the $300, $700, or $900, or $30,000 price the sticker says today.
By our 10% rate of interest and 45 year time frame used above, you’ll actually be poorer by $21,867, $51,023, $65,601, or $2,186,715 at age 67 relative to what you’d have if you had invested the money instead.
Think about that on your next trip to the mall or new car lot!
Congratulations! You’ve now been exposed to the most powerful financial concept in human history. Armed with this understanding, implement it! Teach your spouse, kids, parents, friends about it! Refer them to my blog, and tell them to also do their own research on the topic. You, your friends, and your family can all be wealthy with a little discipline (investing instead of spending) and patience (it takes time to let compound interest work its magic).
Before I end this post, just for kicks let’s assume that your investment earned 12% rather than 10% annually. My opinion is that this is very reasonable for small cap, value oriented stocks if we are in fact in the midst of a long, structural bull market.
At a 12% annual return, that same $100,000 investment would be a whopping $16.4 million dollars at age 67!
To Sum it All Up
Obviously, most of us don’t have a rich uncle that will give us $100,000 when we graduate college. But, we all have the opportunity to invest the savings we accumulate when we forgo mundanely extravagant daily purchases that satisfy our sense of instant gratification.
If we dig deep, I believe we all have the ability to cut expenses and invest the savings.
If we save a little bit each month and invest over time (more realistic for most of us), we will also see the compound interest effect. By saving a little over $450 per month and funneling that money into a Roth IRA ($458 times 12 months equals the full $5,500 allowable annually by the IRS into a Roth IRA) for the 45 year period and 10% rate of return we’ve been discussing would yield $4.8 million at age 67!
You don’t need to have a rich uncle to be a millionaire!
Please comment and let me know if you have any questions on any of this. I’d be happy to walk you through more examples of compound interest, and even help you with your personal goals.