Understanding the Power of Compound Interest

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Albert Einstein once said that compound interest is the eighth wonder of the world. What he was referring to was the nearly magical way that, given enough time, compounding can grow your money powerfully and consistently.

Here is an example; if you have $100,000 and you earned a consistent 6% return, you will have $200,000 in 12 years, $400,000 in 24 years and $800,000 in 36 years! So even though I didn’t earn a greater rate of return in the last 12 year period, you would have earned 400% more than in the first 12 year period! This is the power of time and consistent returns.

Not all compounding is created equal

If I were to offer you a choice, which would you take?

You could have $100,000 or $1 doubled 20 times. Which would you take? If you want the one that would provide the most money to you, the answer is: it depends! See, if you doubled your dollar 20 times, you would end up with $1,048,576!

However, if you applied a 25% tax to each doubling period, you would only receive $72,401.17!! So you see, taxes can make a huge difference. You want to compound your money in an environment that avoids taxation.

When Einstein made his observation, there was a key difference that does not exist today. In his era, there was no income tax, so what you earned you were able to keep. If you want compounding’s power on your side, find a tax free, or at least a tax deferred environment to allow compounding to work fully for you.

The stock market does not compound!

I hear all the time about letting the stock market “compound” my returns. See, for money to compound, you earn interest and then you earn interest on your interest.

With a stock or mutual fund, the value goes up and down, but it doesn’t compound. Wall Street uses the compounding argument to convince folks to leave their money invested at all times, whether the market is going up or down. If the market is going down, you are digging a hole, which you must climb from. With compounding, you just keep earning, no holes to dig out of, corrections, market drops or losses to report or deal with.

As a brief interjection of Wall Street “mathimagic” around compounding: Market boosters will claim that the market averages 10 or 11% returns. While that might be mathematically correct, that isn’t the compound rate of return for the market long term. Our oldest market index is the Dow Jones Industrial Average. It debuted in 1896 at 40.94. As of this writing the Dow Jones Industrial average passed to 20,068 today, a record high. The index’s compound rate of growth over the 120 years since works out to about 5.3% compounded!

In fact, every time you lose money, you jump off the growth curve that compounding provides, and go back to the beginning and start over. This is one of the reasons folks find it so hard to build wealth, they keep starting over.

When you let compounding work for you, the result ends up looking like this:

The important thing to learn from this chart is that when you jump off your compound interest curve, you are cutting off the right side of the chart, not the left side. Isn’t that where you make most of your money?

The high cost of waiting:

I hear people say things like, “once I pay off my house (car, credit cards, loans, etc.) I can start to save” or “when I get a raise, I can start to save”. What those people are missing out on is valuable time.

See, time is an asset, and in many ways it is a more valuable asset than money. That is because small amounts of money over a long period of time can yield huge results.

Consider this example:

Sally is 25 and starts saving $2,000 per year for the next 10 years. If she stops saving at 35, but earns 6% on her money the entire time until she turns 65, she will have a balance of $160,491. If she waited another 10 years at the same 6% before spending her nest egg, she would have $287,408!

Now let’s look at Bob. Bob decided that from 25-35, while Sally was saving $2,000 per year, he would be having a lot of fun and spending his $2,000 each year on vacations and going out. After all, he’s young and it is a good time to have fun. Also, he thinks he has plenty of time to save money. So he starts at 35 to save $2,000 each year at the same 6%. He is going to save it each year until he is 65 and he ends up with $167,603, or about the same as Sally. The difference is Bob had to work 3 times harder to get to the same place (he invested $60,000, while Sally only invested $20,000!

If he had only invested the $2,000 for 10 years like Sally, he would have only had $89,617 at 65! That is about half! So you see how important it is to let compounding have enough time to “do it’s magic” for you.

The Rule of 72’s

Since compounding is so powerful, I would like to share a tool that will help you track how it is working for you (or against you, more on that in a minute). If you take any interest rate and divide it into the number 72, the result will tell you the number of years it will take for your money to double.

So in the example above, if you earn 6%, your money will double in 12 years. (72 divided by 6 equals 12). So if you earn 10%, you will double in 7.2 years, etc.

The way this rule calculates it working against you is in terms of inflation and what happens to your purchasing power. So, if there is 3% inflation, a dollar will be worth only 50 cents in 24 years (72 divided by 3 equals 24).

This tells us that we all need increasing income to maintain a current standard of living both while we are working and after retirement, or you will need to be reducing that lifestyle in that future.

The Wrap Up

We each get a single; lifetime compound interest curve. It is our own choice to take advantage of it and how much of it we put to work for ourselves.

The longer you ride that curve, the greater you will benefit from it, without a possibility of loss! Most people interrupt their curve by taking losses or spending the capital, which just forces us to start over and lose all that great growth on the right side of the chart above.

If you are interested in learning how to put the power of compound interest to work for you, take a minute to contact us and set up a time to talk. We can help you get on your compound interest curve and ride it to a prosperous and secure future.
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