Compound interest – the 8th world wonder?
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I once heard someone say that compound interest was the 8th wonder of the world. There just might be some truth in that. If you really think about the concept it is pretty interesting to see the effects of it and how you can take advantage of it. It’s almost like magic. Taking this principle and combining it with what I wrote in my last post about saving early and often you might just find yourself doing more leisure activities far sooner than imagined. The easiest analogy is the famed snowball concept that isn’t really appreciated until you see the momentum of it chasing you down from behind right before it steamrolls you. I suppose in this instance it doesn’t work to your advantage but in finance it most definitely will.
To most easily understand how compound interest works there is a neat and simple little rule of thumb known to most as the rule of 72. Essentially this will determine how long an investment will take to double given a fixed annual rate of interest simply by dividing 72 by the annual rate of return. Example: suppose you have $50,000 and you are earning 9% interest on this invested in the stock market, it will take roughly 8 years for that money to double and become $100,000. This would occur without making any additional out of pocket contributions by simply taking the money earned each month and reinvesting it.
I found this animated and short video for the more visual learners out there:
The third million is the easiest
There is a saying that making your first million dollars is the toughest. Making your second million dollars is the second toughest. Getting your third million is the easiest of the three. Why? Compound interest and the rule of 72. Let’s take an individual who earns $100,000 a year after taxes for the sake of using round numbers. This person has a 50% savings rate; meaning they are socking away $50,000 a year and using the other $50,000 to fund their lifestyle. For the purpose of simplicity let’s say they don’t have anything saved at the present moment and earn an 8% annual rate of return. It would take 12 years before they had $1M saved.
Now, let’s consider at this point they stop saving and are content just earning their annual rate of return of 8%. It would take 9 years to get their next $1M saved. At this point their savings is sitting at $2M in total. If we keep the same philosophy going their $2M will become $4M in 9 more years. See why the third million is the easiest of the three? We went from $2M to $4M in the same time frame it took to get from $1M to $2M. That’s the beauty of compound interest. In essence, the timeline in our example to go from $0 to $4M in $1M increments is 12 years > 9 years > 4.5 years > 4.5 years. It only gets better from there. If time is on your side you are making your next million in even fewer years after this as you watch your nest egg grow from $4M to $8M. Of course the trick is finding an investment that can earn you 8% consistently.
Oh wait, there is one. Look no further than the stock market. Find a low cost index fund that tracks the S&P 500. At the time of this writing the average annualized total return over the past 90 years is 9.8%. That’s a fairly large sample set that includes a number of catastrophic events to both the US economy and the world stage in the form of the great depression, the great recession, multiple world wars and so on. We aren’t cherry picking the best years here, folks.
I get it…it’s a risky proposition. How do you stay the course? Well, for one thing you don’t let your emotions get in the way…which is what most people do. Somehow human intuition has a funny way of playing a part in most people buying high and selling low. The trick is to just let it ride. Don’t panic and sell when things are bad and don’t sell when you think it reached its peak either. Basically, don’t sell unless you have to because you need the money. And don’t invest the money if you need it in the first place. We are looking at 10+ year time horizons to justify this.
The s&P 500 is the holy grail to some
Let’s look at this graph above. It depicts the distribution of returns over the course of an 88 year period (from 1928 – 2016). 21% of the time the S&P 500 had negative returns greater than 10%. That’s 1/5 of the time or essentially 1 out of every 5 years. But here’s the crazy part, 27% of the time it delivered returns greater than 20%. That’s insane. 66% of the time or 2/3 it resulted in returns of 0% to greater than 20%. This indicates over the course of this 88-year period you typically didn’t lose money. But rest assured, when you did it hurt…but only if you sold because until you do it is only a paper loss.
compound interest is your friend
The best way to become a believer is to learn from your experiences. Simply put, go out and do it. What do you have to lose? If it goes well you are better off than you were before. If for some reason it doesn’t go as planned you take away a learned lesson – and some might say that equates to being better off than you were before as well. If we use data and stats to our benefit odds are more often than not you are on the better end of the equation. It is virtually impossible to get a sure bet. Even casinos don’t have a 100% success rate in their favor. Anything north of 51% is a start.
We won’t always make the right decisions over the course of our lifetime. Certainly not in our investing and finance strategies either. No one can predict the future or the stock market, at least not consistently. But here’s the thing. I once heard someone say that compound interest was the 8th wonder of the world. There just might be some truth in that.
