Compound Interest: The Closest Thing to Money Magic

I think if anyone had pounded home one money concept to me when I was 25 years old that would have been compound interest. Compound interest is the silent force behind every comfortable retirement I’ve witnessed, and why someone on a modest salary could do better than a high-salary earner who started late. When you truly grasp how compound interest works, your savings won’t seem like deprivation; they’ll feel like planting.

Interest on your interest

You get paid for earning money (returns on returns). Your first year of investments will generate a return; in the second year, you’ll be investing with the larger amount generated by that return from the previous year. So while your return in the first year may have been exciting, it’s likely to be much more impressive in the third decade. The initial growth rate will be very slow but eventually become steep as many investors stop investing well before this happens.

A real example, with the math

Let’s give this some real numbers. If you take a monthly investment of $200 beginning at age 25 and earn an average rate of return (as one would expect for a well-diversified stock portfolio) of about 7%, by the time you reach 65, you’ll have invested just over $96,000 of your own money into this account. The value of the account however may be in excess of $500,000. Each dollar greater than that $96,000 was created through compounding; working while you were sleeping, driving to soccer practice and living your life.

The Rule of 72

There’s a shortcut for picturing all this. Divide 72 by your yearly return and you get the rough number of years it takes money to double. At 7%, that’s about every ten years. So a dollar invested at 25 becomes two by 35, four by 45, eight by 55, and sixteen by 65.

Notice where the big jumps live: at the end. The last doubling adds more than all the earlier ones combined, which is exactly why staying invested matters so much more than starting big.

Time is the ingredient you can’t buy

You can’t go back and get those lost years. That’s a big reason why investing a little each month in your 20s will almost always beat investing a lot later on in life, since the earlier investments have the most time to double. Money invested today may catch some of these doublings further down the road. There isn’t one “best” day to begin saving; however there are two good days. One is yesterday, and the other is today, for both 25-year-olds and 55-year olds, that’s.

It works against you too

One important note of caution, the same process works backwards with debt as well. Credit card balances are compounded against you every day at much higher rates than virtually all investments generate a reliable return for. That’s why if your interest rate is 22%, making an investment that earns less than that while your money just sits there likely doesn’t make sense, and likewise, the guaranteed return from paying off high-interest debt. Compounding has no preference for which side of it you’re on; your task is simply to get on the correct side.

Where to put it to work

You can create wealth using compounding, which requires just one element of your control and that’s time and location (place) to compound. If you want to be as passive as possible when creating wealth with compounding, I’d recommend starting at your workplace 401k or if available with an employer match. Next in line would be the traditional IRA. Set up a monthly transfer from your paycheck into the account as close to automatic as possible. Keep it diversified but low cost so that you don’t have high fees eating away at the money you put into the account. Leave it alone after this and let time take care of growing your money. It’s usually those people who stop looking at their balance and allow many years to pass before they realize how much money has been created through compounding, that end up collecting most of its magic. You don’t need thousands of dollars to begin investing; you simply need some money each month placed in a vehicle with steady growth over long periods of time until the curvature of time creates an upward trend.

The real cost of waiting five years

You don’t have to look far for a case in point on the force of compounding; just consider the cost of inaction. Take an example: put $300 a month to work at 7 percent from age 30 and you can count on having about $540,000 by 65. Make it 35 when you begin, with all else being equal, and the math is quite different. A five-year head start isn’t worth merely five years of your $300. In the end, that kind of procrastination will set you back more than $180,000, since the money you left on the table had the most room to grow. It’s a hard truth: if you could have started in the past, fine. If not, do it now.

It’s a case of the little and often. That’s what puts a small sum put away early in front of a large one that comes later on. Take a person who’s frugal in her twenties; she will usually be in better shape than one with more to put aside but who doesn’t begin until her forties. Time has a way of making up for the difference. You can never make up for lost years down the road, so the only thing to do is to put something to work now.

Reinvest the dividends, or leave half the magic on the table

Dividends are the cash a company puts in the hands of its shareholders, and they make up a portion of any return on the stocks or funds you hold. The option is there to put that money to use or have it put back to work by buying into more shares. It may seem like a minor decision, but over time it makes a world of difference. In fact, much of what has driven the market’s growth in the long run is down to dividends being cycled back in instead of left as cash, since those new shares go on to generate their own yield.

You can set up automatic dividend reinvestment in the majority of retirement plans and with your broker in one fell swoop. After that, it’s out of mind. It’s an unobtrusive way to put a lot of work in on the back end, where a series of modest payouts will have you in a much better position down the road.

What quietly eats your compounding

There are two things that will put a damper on compounding, and they have a way of slipping by you since their effects are so gradual. Take fees for instance. The difference between a 1 percent annual charge and a 0.1 percent one may not seem like much in the moment. Yet put in thirty years and you’ll see it has siphoned off tens of thousands in value. It’s money that’s no longer working for you, but for the fund company. One of the main reasons to go with a no-frills index fund is to put an end to that kind of leakage.

Think of it this way. The other adversary is the temptation to make a withdrawal. When you take from a long-term holding to put out a fire you might have put out some other way, the cost is more than the dollar in hand; it’s all the dollars that would have come from it down the line. An emergency fund is what an investor needs for precisely this reason. It’s there to see the portfolio through hard times without having to touch it, and that’s when compounding has the most to offer.

A realistic rate to plan with

There’s an allure to running a retirement calculator with some rosy figures and basking in the outcome, but any plan worth its salt will be built on more conservative numbers. If one looks at the history of a well-diversified stock portfolio over time, 7 percent is what you can expect in real terms once inflation is factored in. Add some bonds to the mix as the years go by for a bit of stability and the return eases off. Sticking with a 6 or 7 percent figure is the way to have a realistic view of where things are headed.

If someone is touting a no-risk, double-digit return on an ongoing basis, it’s best to be skeptical. There’s no such thing. In reality, returns are a bit of a rollercoaster and can be volatile from one year to the next. Compounding only does its job when you put up with the lean years rather than making a run for it when things are at their lowest. You have no say in the rate of return, but you can be as consistent as you like.

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