There’s an infamous slogan in Chicago politics, “Vote early and often.” My professional advice: don’t do that. Instead, I prefer: “Invest early and often.”
We’ll call it the new Chicago way.
When you invest early and often, you can take advantage of the power of compound interest.
There’s very little we can control when it comes to investing. One of the main things we can control is how early we prioritize investing.
In today’s post, we’ll learn what compound interest is and why it’s so powerful in generating long-term wealth.
Invest early and often to benefit from the magic of compound interest.
Compound interest is the interest you earn on interest.
How’s that for a confusing definition?
Fortunately, the idea of compound interest makes a lot more sense with a simple example.
Let’s say you make an initial investment contribution of $1,000. Let’s assume that you earn 10% interest each year on that investment. We will also assume that you re-invest your investment gains.
After the first year, your initial contribution of $1,000 earns $100 in interest (10% of $1,000). That means after one year, you have $1,100 in your investment account.
Because we are re-investing our gains, that means that at the start of year two, yo have $1,100 to invest: $1,000 from your initial contribution plus the $100 earned in interest.
If you earn the same 10% interest on that $1,100 investment, you will have $1,210 at the end of year two.
Notice that in year two, you earned $110 in interest, whereas in year one you earned $100 in interest. That’s because in year 2, you earned interest on the interest your previously earned.
This is the key point about compound interest: you earned more money in year two, even though the interest rate remained the same and you did not contribute any additional money.
That’s how compound interest works. Compound interest is earning interest on interest you’ve previously earned.
So, why is compound interest so powerful?
Earning an additional $10 in interest year two may not seem like a lot.
Over the long run, those additional earnings add up.
Let’s look at an illustration from investor.gov of what happens to that initial $1,000 contribution over a 30-year period:
In 30 years, you will have a total of $17,449.40. That’s a pretty good result from total contributions of only $1,000.
However, for this example, that total is not the important part. The important part is to visualize how compound interest worked its magic to get that result.
Look closely as the two lines on the graph. The blue line that doesn’t change represents your initial $1,000 contribution.
The red line represents the amount of money you have over time.
Notice how in the first 10 years or so, the red line and blue line mirror each other pretty closely. Around year 12, you start to see some separation between the two lines.
While the blue line stays flat, the red line begins to arc upwards. That’s because all that interest you earned during the previous decade has been earning interest. Your investment begins to accelerate upwards without any additional contributions from you.
By the end of year 30, look at how steep the red line is jetting upwards.
We can look at the specific amount of money you’d earn each year in this hypothetical to really drive this point home.
As we mentioned earlier, you earned $100 in interest during year 1. Then, you earned $110 in interest during year 2. That’s a good, but modest, increase.
During year 12, you earned $285.31 in interest. That’s significantly more than you earned in the early years, all without any additional contributions on your part.
During year 30, you earned $1,586.31 in interest!
The more time that you stay invested, the more money you’ll earn as compound interest works its magic.
That’s the power of compound interest.
Invest early and often to be a millionaire with very little effort on your part.
Compound interest is so powerful that it can make you a millionaire with very little effort on your part. All it takes is time and consistency.
In other words, invest early and often.
Let’s look at another example to see how you can easily become a millionaire if you invest early and often.
Let’s say you begin your career after going to law school or grad school at age 25. During your first year working, you saved up $3,000 and decided to invest in a low cost index fund.
You also make a plan to contribute an additional $300 per month to your investment account for the next 40 years, setting yourself up to retire at age 65.
We’ll also assume you earn the same 10% interest from our prior example, and you don’t make any withdrawals from your account.
By the time you reach retirement age, you’ll have $1,729,110.97 in your retirement account!
That’s after contributing only $3,000 initially and $300 per month after that.
Put another way, your total contributions of only $147,000 turns into $1,729.110.97 by the end of your career.
Let’s look at the graph corresponding with these figures to once again visualize compound interest at work.
You’ll notice this graph looks almost identical to our prior example, even with the additional contributions that you make over time.
You can once again see that the blue and red lines mirror each other closely for the first 10-15 years.
Then, the blue line stays relatively flat while the red line gradually arcs up before skyrocketing towards the end.
Your personal investment picture should look similar in the long run.
Now, there’s no way to predict exactly when you’ll start to notice the magic of compound interest. There are too many variables at play.
The point is that given enough time, your personal investment trajectory should look similar because of compound interest.
You can play with the numbers in an investment calculator like the one available at investor.gov to match your personal situation.
If you’ve created a Budget After Thinking, you may be able to invest much more than $300 per month.
No matter what initial contribution you make and what interest rate you assume, you should notice a similar investment picture over the long run.
When I say investing is the easy part, this is what I mean.
I just showed you how an early contribution of $3,000 and regular contributions of $300 can turn into more than $1.7 million.
You don’t have to understand the math behind compound interest.
You just have to trust that it works.
Then, invest early and often.
Given enough time, assuming normal, historical market conditions, your investments will gradually increase before shooting up in the later years.
Read that sentence again. “Given enough time” is the key phrase.
The magic behind compound interest is time.
The earlier you can start investing, the better off you will be.
Since we can’t control investment returns, I prefer to focus on what we can control when it comes to investing.
We can control when we start investing and how long we invest for.
By making regular contributions over a long period of time, compound interest ensures that your wealth will grow.
Invest early and often.
$3,000,000 today or a penny that doubles each day for the next 30 days?
Let’s look at one more fun example to demonstrate the power of compound interest.
At the start of each personal finance class I teach, I ask my students this question:
“Would you rather have $3,000,000 today or one penny that doubles each day for the next 30 days?”
Maybe the fact that I’m asking the question in the first place gives away the answer. Still, some students refuse to believe that the penny could grow to more than $3,000,000 in 30 days.
The real lesson in asking this question is not that the penny ends up being worth more. The lesson is that it’s not until the very end of the time period that the penny takes the lead.
Check out this graphic from TraderLion:
If you chose the penny, for the first 20 days, you’d be feeling pretty foolish. Even after 29 days, the penny still hasn’t outpaced the guaranteed $3,000,000.
Then, by day 30, you realize the full power of compound interest. The penny ends up being worth $5,368,709.12!
Just like we saw with our prior examples, it takes time for the magic of compound interest to do its thing.
When it comes to investing, time is the most important factor that we can control. The more time you spend in the markets, the better chance you have of significantly increasing your wealth.
People smarter than you and me preach the power of compound interest.
Warren Buffett, the world’s greatest investor, fully appreciates the power of compound interest. He’s famous for saying that his favorite holding period for an asset is “forever”.
Buffet’s not literally saying that there’s never a time or reason to sell an asset, like a a stock. He’s simply making the point that compound interest benefits people who stay invested over the long term.
If the world’s greatest investor isn’t impressive enough for you, how about the world’s greatest thinker?
Albert Einstein is often credited with this famous quote about compound interest:
Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.
You don’t have to be as smart as Buffet or Einstein to benefit from compound interest.
You just have to invest early and often.
The Chicago Way: Invest early and often.
Let’s recap:
- Voting early and often = bad idea.
- Investing early and often = good idea.
Whether you are new to investing or have been investing for some time, never underestimate the power of compound interest.
It will take time before you see results. But, the only way you’re going to get those results is by staying patient and staying invested.
When you’re tempted to pull out of the market, remind yourself that investing is a long-term game.
Picture the graphs that show how your money can skyrocket with enough time. Remember the question about the penny doubling for 30 days. Don’t ignore the words of Buffett and Einstein.
Let compound interest do its thing.
Invest early and often. It’s the new Chicago way.
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