subject: The Incredible Power Of Compound Interest [print this page] The Incredible Power Of Compound Interest
Compound interest is often called the eighth wonder of the world because it seems to possess magical powers and because it applies to money, it helps you achieve your financial goals. In fact, it was none other than Albert Einstein who said " Compound interest is the most powerful force in the universe!"
Consider this question: would you rather have 10,000 a day for 30 days or a penny that doubled in value every day for 30 days? Most will know to choose the doubling penny. That's because at the end of 30 days, thanks to the power of compound interest, you would have over 5 million instead of 300,000.
Now let us consider the case of two investors, Simon and Peter, who would both like to become millionaires by the time they reach retirement. If Simon put 2,000 a year into the market between the ages of 24 and 30, which earned him a 12% net return, and that he continued to earn 12% a year from until he retired at 65. Peter also put in 2,000 a year, earned exactly the same return (12%), but waited until he was 30 to start, although he then continued to invest 2,000 a year until he retired at 65. In the end, both have around 1 million. However, Simon had to invest only 12,000 (2,000 for six years), while Peter had to invest 72,000 (2,000 for 36 years). This was six times the amount that Simon invested, just because he waited six years to start investing.
Investing early, is at the very least, as important as the actual amount you invest over your life. Therefore, to truly benefit from compounding, it's important to start investing early. After all, it's not just how much money you start with that counts; it's how much time you allow that money to work for you. Staying calm and reassessing our goals and our appetite for risk is essential to keeping us on the right path.
In addition to the amount you invest and an early start, the rate of return you earn from investing is also crucial. The higher the rate, the more money you'll have later. Going back to the previous example, let's assume Simon had two sisters who, at 24, also began saving 2,000 a year for six years. But unlike Simon, who earned 12%, sister Lucy earned only 8%, while sister Jenny did not make wise investment decisions and earned only 4%. When they all retired at age 65, Simon would have 1,074,968, Lucy would have 253,025, and Jenny would have only 56,620. Even though Simon earned only 8 percentage points more a year on his investments, or 160 a year more on the initial 2,000 investment, he would end up with about 20 times more money than Jenny. A few percentage points in investment returns or interest rates can mean a huge difference in your future wealth.
Of course saving in your 20's for retirement entitles you to take more risk by investing in more volatile assets such as equities, as you are unlikely to need access to that money in the short term and can ride out the storms over the years by remaining invested in any periods of volatility. For most of us when approaching retirement, it is a time of our lives where we need to reduce risk and move our funds into more stable income generating assets, such as bonds for example. The new danger that presents itself now is inflation. This is where the power of compounding works in an equally powerful way, but going against you in the other direction!
Consider that Simon decided he wanted to retire earlier at age 60 and had a accumulated a fund of 600,000. Simon is in good health and expects to live at least as long as his father, who died at the age of 80. If inflation over the next 20 years was to average 2% p.a., his capital would need to grow to 888,000 over the 20 year period just to retain the same spending power as when he retired at age 60. If inflation averaged at 3% per year, his fund would need to grow to 1,080,000 to retain its original value. So just as compound interest can multiply your savings, compound inflation can multiply the effects of inflation.
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