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Investing – The wonders of compound interest
Before we get into the nuts and bolts of investing and compound interest, the most important concept we need to discuss is time.
Specifically, the earlier you start in life, the better.
I’ll be blunt. There are only two tried and tested ways to become wealthy;
- Create a business that becomes spectacularly successful (this is not beyond the realms of anyone). Far easier said than done though. But possible if you understand and apply everything I’ve tried to teach you about goal setting and who YOU need to become to realise those goals. In most instances, the you now, is not the you that can create a massive business. YOU need to evolve.
- Save, Invest and start as early as possible. Not sexy, I know. It doesn’t sell anywhere near as many books as point one above, but it works.
How wealthy you want to become, that is entirely up to you. Money is not the most important thing in life, but it makes life easier when you have enough.
Freedom in life comes when you have enough money. Once again, enough money is a very personal matter. You may be content with a little. You may want a lot. But as long as you have enough to do what you want to do and to pay for life’s emergencies, you’ll be content.
Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
It doesn’t matter if he actually said it or not. But the content of the message is 100% spot on.
So. What is compound interest?
The eighth wonder of the world
Put simply, compounding occurs when the money earned from investments is reinvested for the chance to earn even more. The interest earned and reinvested makes more money (compound interest or compound earnings).
In the above chart we start with $5,000 earning 10% per year. We reinvest the earnings and make no additional contributions.
Reinvesting means putting the earnings back into your investment. This is opposed to taking it and spending it.
In the beginning, it’s not exciting. Your initial investment is doing all the work and it’s slow going.
Between years 10 and 20, we start to see more action, the interest you earn is generating interest of its own at significant levels.
Between years 20 and 30, the compounding effect is accelerating.
If you did not reinvest and spent the earnings, the total benefit to you, including the original $5,000 is only $20,000 over the course of 30 years. You are only earning $500 a year (10% interest) then you spend that $500 each year ($5,000 plus 30 x $500 = $20,000).
Compare this to having $87,000 after 30 years. You missed out on $67,000.
Now let’s amp this up.
The next phase is to regularly add to the investment. $5,000 per year.
Over the course of 30 years, you have invested $155,000 and your investment is worth nearly $1 million.
This is how people get wealthy. After an appropriate length of time, you can switch from reinvesting to living off the income your investment is generating.
That’s financial freedom.
Now as a 20 or 25 year old, you’re thinking I don’t want to wait that long.
Given that most of us won’t have a hugely successful business, this is your only option.
This is the difference between the haves and the have-nots! The mindset of long-term success.
In reality, you’ll be in the same boat as everyone else early on. The only difference will be that in your 40’s or 50’s, you’ll have a reservoir of funds able to provide you with enough income to replace your employment income for the rest of your life.
Your superannuation (a quick aside)
You may or may not have noticed, but this is how your superannuation fund works.
When you earn an income as an employee, you should receive payments into your superannuation fund.
Let’s say you earn $50,000 a year. Your employer should pay $5,000 on top of your income, into a superannuation account. This is why I included the additional contributions in the example above.
Your superannuation is the slow burner, that becomes the fast burn through the decades. The better you nurture it in the early years, the more it grows later on.
Back to our main point……
Compound Interest – Why time is so important
The chart below shows the same investment strategy – initial investment of $5,000 with an annual $5,000 contribution, reinvestment of income and earning 10% per year. We have three people starting at three different ages.
Look at the massive difference by starting at age 15 vs 25 vs 35.
Time in the market is everything.
I fully understand that not every 15 year old can do this.
The point is time in the market.
The earlier you start the better.
You can easily see why the rich keep getting richer at a faster rate!
They started off just like you. They took some calculated risks, focused, worked hard and played the long game.
Competing interests
Not everyone wants to be so disciplined with investing and not everyone can.
Your priorities in life will direct your investment strategy.
You may want to buy a home, send your kids to private school or sacrifice additional income for a work-life balance.
All of that is fantastic.
But if you are not aware to the possibilities in life and the consequences of the decisions you make, you are walking blindly into your future.
The Scott Pape demonstration (a.k.a The Barefoot Investor)
This highlights the power of starting early. Scott Pape did this demonstration in one of his books.
The rules:
- Assumes 10% per year return.
- The Gold person starts investing at 15 and puts in $5,000 until the age of 24 (10 x $5,000) and then never adds to it again. All earnings are reinvested. A total investment of $50,000.
- The Blue person starts investing 10 years later at age 25 and adds $5,000 per year until age 60 ($5,000 x 36). All earnings are reinvested. A total investment of $180,000.
The Gold person starting at age 15 romps it in. $2.71 million to $1.65 million. However, invests $130,000 less of their own money.
The power of time.
You don’t need to understand the maths behind it. Just take it as fact. But feel free to look into it.
The other key consideration is that if you start late, you need to contribute significantly more every year to end up in the position as the Gold person.
In the Pape demonstration, at 25, you would need to start with $8,000 and invest $8,000 per year to end up in the same position as starting at 15 (Gold). Total investment required from your savings = $8,000 plus $8,000 x 36 = $296,000.
The wrap
I hope you now understand the power of your money making you more money and how time creates a snowball effect.
The longer it rolls the bigger it gets. If you start late, you need to start with a significantly larger snowball to catch up!
When making goals and working out plans, start with the end in mind and then try and work backwards.
If you want an income of $100,000 per year, how big an asset base do you need? If we assume a return of 5%, you need $2,000,000.
The next question is how long it will take to accumulate $2,000,000. This, of course, depends on how much you can afford to save every year. $5,000, $20,000, $50,000?
Is this realistic?
Or a better question, what do you need to change in order to achieve your goal?
Additional reading:
- The FIRE Movement (Financial Independence, Retire Early) – this may be a little hard core for a lot of you. I don’t do this, but you should know about it.
- Compound interest calculators. Play around with the figures. Watch a video on how it works.
Up next …..
Investing – The big picture Part 1.
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