Why is Compounding Important When it Comes to Investing?
Good Question – in fact, this question is at the CORE of ALL investing!
First, let’s define the two types of return you can earn on an investment:
Simple Interest: This is interest that is based on the principal amount of a deposit (or loan). Passbook savings accounts at your bank are an example of simple, interestbearing accounts.
Example: if you earn a Simple Interest return of 7% on an investment of $10,000 over 20 years, at the end of that 20 years, you would have $24,000. The calculation for this is: $10,000 x 0.07 x 20 = $24,000. (Only the initial investment of $10,000 earns interest.)
Breaking down the mathematics of Simple Interest, in the first year, you would have $10,000 times 0.07 = $700. In the second year, you would have $10,000 times 0.07 = $700. This calculation is the same with each iteration, and continues for 20 years, repeating $700 x 20 = $14,000 + the initial investment of $10,000 = $24,000.
Compound Interest: This is interest calculated on the initial principal as well as on the accumulated interest of previous periods. In each period the intest accumulates and you earn new interest on the previous principle PLUS the earned interest.
Example: if you earn Compound Interest of 7% on an investment of $10,000 over 20 years, at the end of the 20 years, you would have $38,000 – nearly 60% more than the earnings from Simple Interest over 20 years.
Breaking down the mathematics of Compound Interest, in the first year, you would have $10,000 times 0.07 = $10,700. In the second year, you would have $10,700 (the principle from the first year, including interest/return from the first year) times 0.07 = $11,449. In the third year, you would have $11,449 (the principle from the first two years including interest from the first two years) times 0.07 = $12,250.43, and this continues each year for the duration of the investment.
In this example, the calculation continues for 20 years, repeatedly compounding the growth of the principle+interest – times the interest rate – with the principal AND steadily growing interest being compounded for 20 years = $38,696.84.
That’s about 60% more than the return you would attain from Simple Interest. If you examine 40 years of compounding (an avg. working lifetime), you would have $38,000 from the Simple Interest calculation – and $149,745 from the Compound Interest calculation – that’s a 294% difference, or nearly triple the return of Compound over Simple Interest!
With Compound Interest, Time is Your Biggest Asset
Always keep in mind that Simple Interest accumulates arithmetically (this is the way many passbook savings accounts operate) while Compound Interest accrues geometrically (the accumulation you receive from the stock market).
An example of arithmetic growth is 200, 400, 600, 800, 1000. In each period, the value grows by 200.
An example of geometeric growth is 200, 400, 800, 1600, 3200. In each period, the value is doubled.
It's easy to see that you want geometric growth rather than arithmetic growth. Geometric accumulation of capital achieves a radically more significant result than the arithmetic accumulation of capital. This is also the reason you want to consistently reinvest any dividends paid on an Equity or ETF investment – the amount upon which you are earning interest grows with every period.
Compound Interest – with geometric growth – is what investors receive in the stock market.
RealLife Example: If you save $10,000 per year for the 40 working years of the average person (age 25 to 65), with compound annual interest rate that averages 10%, you would have $4,868,518 at age 65. Yes, that's an account worth more than $4 million – from a total savings of just $400,000 over 40 years. For most people, $4 million is a ample amount upon which to retire (depending on the lifestyle you desire).
If you are looking for a better return – without risking the possibility that your planned retirement happens at the same time as one of the market's regular 50% losses during a recession – that you need ETFOptimize.com. Our systematic investment models have produced an average annual return of about 30% over the last 20 years. (Past performance may not be indicative of future returns.)
WARREN BUFFETT’S EXAMPLE
Compound Interest explains how a person who is not wealthy – such as Warren Buffett when he graduated from Columbia University in 1951 – and become extraordinarily wealthy over time. Buffett started with an investment of just $500 of his own money at age 23, formed an investment partnership (Buffett Partnership, LTD.), and today (about 80 years later) he has become one of the wealthiest people in the world (and the world’s most successful investor of all time) with a net worth of around $80–90 billion.
The key to putting the magic of compounding to work for you is to get started NOW – not next week or next year. Time is your biggest asset to make compounding make you wealthy.
Even if you don’t desire to be wealthy – perhaps you want to retire early – or have the financial freedom to live your life YOUR WAY.
If you can attain a steady return of 20% or more, and start saving at the age of 20–25, you will have enough funds to retire in about 20 years (age 45). That's HALF the number of years that most people spend being a slave to the office!
That’s what our firm has focused on providing to customers – attaining that steady, 20% annual return. There are several ways to get there – but most importantly, you must have discipline in your effort to save!
