“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” - Albert Einstein
How dramatic is the effect of compounding?
For finances, and nearly anything else, the value of compounding grows exponentially logarithmically, not in linear fashion.
This means that as you move along the horizontal (x) axis, the growth on the vertical (y) axis grows exponentially.
Frequently, in the personal finance community, we value money on the horizontal (x) axis, and net worth or money on the vertical (y) axis as follows:
After 10 years, your initial $10,000 (assuming you added nothing else), grows to only $19,990. Not bad, but this will not get you rich.
After 20 years, your initial $10,000 (again assuming you add nothing), grows to $43, 157. Again, not too bad considering you never added another dime - which is typically very unrealistic for those interested in saving and investing.
Fast forward to the 50 years mark, your initial $10,000 investment turned into a whopping $434,274. Again, this does not adjust for inflation and just shows you what your initial dollar amount will potentially turn into after 50 years of passive index fund investing.
The Power of Saving PLUS Compound Interest
You may feel somewhat underwhelmed after that first example. That is fine. The power of compounding is quite dramatic, however some folks argue and become upset when they hear about 50 plus years of investing. It might just be too far out for most people to imagine and remain motivated on the path to F.I.
This is where demonstrating the power of saving plus compound interest comes into play.
Take our initial investment of $10,000, use the same parameters of hypothetical growth at 8% compounded annually, and add $500 a year.
This time it only takes 43 years to cross the $400,000 mark. At the end of 50 years, your initial investment of $10,000 plus an additional $500/yr, compounded at 8% annually, turns into $720,000.
Now what if you simply take your initial investment of $10,000, and add $5,000 per year to an IRA, compounded annually at 8%. Essentially this would be nearly maxing out an IRA every year ($6,000 contribution limit as of 2020).
Following this process of $10,000 initial investment, plus $5,000 contribution annually to an IRA, compounded at a hypothetical rate of 8% annually - you would be a millionaire in 36 years with your investments growing to $1,078,364.
At the 50 year mark, you'd have potentially $3.3 million in the bank. Not too shabby.
So what does this all mean...
As you can see, compound interest takes time to reveal its' magic. The earlier you start, the longer you have for compound interest to work in dramatic fashion.
Consider the rule of 72. Take your annual interest rate (in our example 8), and divide 72 by your rate. This will tell you how many years it takes your money to double.
In our example, 72/8 = 10.3 years. In other words, every 10 years our money would double.
How do I make compounding more powerful?
As you can see, each of our models demonstrates - after a hypothetical return - a "hockey stick" growth curve. This means your money compounds and grows exponentially upward instead of a straight line.
Of course, this does not happen consistently. The stock market returns look nothing like a smooth line the way our model shows.
The market is actually quite volatile. It takes hard dives and high climbs based on investor behavior, consumer sentiment, inflation, pricing, GDP, etc. Many factors determine market returns.
Most estimates, in the 200 plus year history of the stock market, reveal returns in the 8-10% range. Remember, this is just an average. Do not expect these returns on a reliable and consistent basis. Some years will be higher, and some years will be much, much lower.
However, unless you are assuming that America will "go out of business", there is a potential way to improve the power of compounding.
The concept is quite simple...
START WITH A HIGHER INITIAL INVESTMENT.
To illustrate my point, say you start with an initial investment of $100,000, instead of $10,000. Do not add another dime to that $100,000. Ever.
In 50 years, after an 8% return compounded annually, you'd see your initial investment grow to...
This is approximately $1.4 million more than what you would have compared to if you initially invested $10,000 plus $5,000 a year compounded at 8%.
To illustrate this point further, in the model representing a $10,000 initial investment plus $5,000 annually, you will have contributed a total of $260,000 of capital with a final worth of $3.3 million.
By starting with a greater initial investment, not only will you be worth $1.4 million more - at a total of $4.7 million - but you will contribute $160,000 less of your own capital.
The power of compound interest is one of the primary motivators that keeps me steady on the path to F.I.
Consider visiting a compound interest calculator and plugging in your own numbers.
Remember, our models and examples are completely hypothetical and do not represent real returns, nor are they adjusted for inflation. In no way is this a guarantee of returns. Please seek guidance from a financial professional, of which I am not.
Still, the point remains. The dramatic effects of compound interest are on display.
The most optimal recipe would be to start big and start young. Nevertheless, conventional wisdom and investors agree that although investing as young as possible is key, the next best time would be to start ASAP.
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Further, take a look at our favorite resources that built the foundation for our awareness of financial independence, frugality, and investing.
Dr. Jon is a physical therapist by day, and a dedicated frugalist by night, deeply enthralled in the thrill of "pinching pennies" and investing the margin.