“Compound interest is the 8thwonder of the world.”– attributed to Albert Einstein
Principles of Wealth #36*
Most wealth seekers believe they understand “the miracle of compound interest” – how saved money grows over time. Most see this growth as steady, like the gently ascending slope of a hill. But the curve is nothing like that. And the difference is very important.
Here’s a fact: A single $10,000 investment in a retirement account that appreciates at 10% annually will turn into $1,173,908 in 50 years.
That’s a nice little nest egg, considering it began as a one-time investment of only $10,000. The value seems almost unbelievable, don’t you think?
It’s due to what financial planners call “the miracle of compound interest.”
The beauty of compound interest is that it allows you to earn interest on your interest. And while you have to sweat to earn the money you initially invest, from then on, your money works on your behalf.
But the “miracle ” is often misunderstood. On a chart, the growth would look not like a hill but a rake. It builds very slowly for the first 20 years. It picks up a bit between 20 and 30 years. And it then moves almost vertically. So although the value of your nest egg over 50 years is still miraculously high, the values over 10, 20, 30, and 40 years are much less impressive.
After 20 years, the value is only $67,275. After 30 years, it is only $174,494. It only begins to look like an actual retirement account after 40 years (at $452,592). And it’s not until year 49 that the value breaks through the million-dollar barrier.
When I first discovered the reality of how compound interest works, I was disappointed. It meant that unless you could keep your investment compounding for a long time, nothing miraculous was going to happen.
Let’s assume you put $10,000 in an index fund when you’re 25 and add $2,400 a year to it. Forty years later, when you’re 65, you will have roughly $1.5 million in that account.
But if you don’t start saving for retirement until you are 45, it’s going to be a different story. That same $10,000 initial investment plus the same added $2,400 a year will turn into only about $205,000 when you’re 65.
Yes, the reality of compound interest is both amazing and depressing.
The amazing part is that you can pretty much guarantee that your grandchild will retire a multi-millionaire if only $10,000 is invested in his name in a stock index fund at the time of his birth.
The disappointing part is that anyone that waits until he/she is 40 or older to save for retirement is not going to be able to take advantage of this financial miracle. There is simply not enough time.
But disappointment is better than delusion. Understanding the limitations of compound interest can be a good thing if it spurs you to face reality and develop ancillary plans.
And by ancillary plans, I don’t mean buying more risky stocks. I mean creating additional streams of income and learning how to “live rich” within a budget.
* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost.