“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Compound interest is the most powerful force in the universe.
Compound interest is the greatest mathematical discovery of all time.”
~Albert Einstein (source: quotesonfinance website)
I’ve been amazed at the power of compounding ever since my mom explained the Rule of 72 to me many years ago. This simple exercise shows how long it will take for your money to double at a particular interest rate. Divide the expected interest rate into 72 and you have an approximation of how long it will take for your investment to double at the given interest rate. For example, if your projected return is 9 percent, then you divide 9 into 72 and the result is 8. According to the rule of 72, it will take approximately 8 years for your money to double at a 9 percent interest rate.
More recently – as I see the traditional retirement age coming into view- I’m doing some portfolio analysis to assess our financial picture now and into the future. One of the thing that amazes me is a particular TIAA CREF retirement account I contributed to decades ago when I worked at San Diego State University. I contributed to this account during my ten years of employment and invested 75 percent of my allocation in a diversified stock fund and 25 percent in a fixed option. After those ten years were up, I never contributed again nor did I change the asset allocation.
Several decades later, the account value has increased 6 times. That means if I invested $35,000 during those ten years, that account would be worth $210,000 today. It still amazes me as I write this article how a mere $300 or so dollars per month invested conservatively for ten years grew to a respectable sum. When calculating the annual average rate of return on that account, it was approximately 6.75 percent. This is a very attainable rate of return.
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Investing is a Long Term Path to Wealth
Many individuals are seeking multiple streams of income and wealth building strategies through blogging, affiliate sales, freelance work, and product creation-on top of full time jobs. There’s no doubt that all of these endeavors will create additional income. But what you do with the extra income you earn, can make the difference between a stress free retirement and one filled with money woes.
By understanding about how modest sums of money, invested today for the long term, can create a path of lifelong financial comfort you will be giving yourself a wonderful gift.
I’m so committed to promoting smart investing practices, I wrote Invest and Beat the Pros-Create and Manage a Successful Investment Portfolio (on sale now at Amazon).
Here’s a sample from “Chapter 7-Quick Start Guide for a 6-7 Figure Retirement Account”.
“Juan’s Investing Story
At age 25, Juan started contributing $350 per month into his retirement account. He automatically transferred the money from his paycheck into the account. He decided to invest 25 percent in a bond index fund and 75 percent into an all world stock index fund.
Assume 7 percent average annual investment returns.
Juan’s employer kicked in an additional $175 per month, for a total monthly retirement fund contribution of $525. Each year, Juan invested $6,300 for retirement; $4,200 payroll deduction along with the employer’s $2,100 matching contribution.
After setting up the transfer and choosing the funds, he didn’t think much about it.
After a small input into savings for emergencies and short-term goals, Juan spent the rest of his paycheck, knowing his financial future was secure.
Over 40 years, when Juan reached the age of 65, his $168,000 investment plus the employer’s $84,000 (total contribution of $252,000) grew to over $1,386,065.
Juan never increased his retirement contributions!
Imagine if Juan had increased his contributions as his income grew. With compounding returns, your original investment makes money on top of money.
Look at the retirement contributions in a different way.
Juan invests $4,200 each year. That’s 10 percent of a $42,000 income. Yet, $4,200 per year is only 7 percent of a $60,000 salary. As Juan’s salary increases, he can contribute a smaller percent of his income and still reach over a million dollars by retirement, or, as his salary increases, he can choose to increase his retirement contributions.
The key to building a large nest egg for the future is to start investing younger, to give your money more time to compound.”
If you’d like to read more about creating an investment portfolio, download Invest and Beat the Pros-Create and Manage a Successful Investment Portfolio (Kindle version now on sale).
The Takeaway
No matter how old you are now, or how much money you earn, find a way to commit a few dollars per month investing in diversified index funds. Start now, continue for the long haul, and your future self will thank you. With the benefit of compounding returns, relatively small amounts of money, invested over the long term can lead to a nice future nest egg. So many folks allow fears or lack of knowledge stop them from getting started. Don’t let those apprehensions deprive you of the life you deserve.
Barbara Friedberg, MBA, MS is a former investment portfolio manager, author of Invest and Beat the Pros-Create and Manage a Successful Investment Portfolio, Personal Finance; An Encyclopedia of Modern Money Management and How to Get Rich; Without Winning the Lottery. Friedberg is a former university Finance and Investments instructor, and publisher of Barbara Friedberg Personal Finance.com. Her work has been featured in Investopedia, U.S. News & World Report, Yahoo!Finance, Bankrate.com, and many more publications.
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Congrats on your book! That’s an impressive accomplishment. It sure is nice how a little can go a long way over time. I agree the rule of 72 is quite a neat one. It’s funny how math works sometimes isn’t it? :)
Hi Sydney, Thanks so much for the gook wishes. I guess that’s a bright side of piling on the decades – compound investment returns. I’m hoping I can inspire others :).
I teach a personal finance class to Middle School Students and they are always blown away when I show them the graphs of starting early vs waiting 10-15 years to start investing in a retirement account. I have found that budgeting and impulse control are huge factors influencing the financial decisions of many individuals. Congrats on the book Barb and best of luck!
I’m reading your book right now, Barbara, and I appreciate the gift you have for explaining complex ideas in an understandable way. Thank you – you inspire me to save and invest more!
@Frugal Toad-It’s great that you teach a class to middle schoolers. That’s the perfect time to make an impression. How do they respond to the topics?
@HappySimpleLiving-You are too kind. If you’re saving and investing-then I’m doing my job :)
Congratulations on publishing a new ebook! I’m currently trying to figure out how to do one myself. Compounding returns are always such a good thing to re-enforce with all levels of investors; especially those just beginning. I can’t tell you how many times I’ve amazed people when I bring up some online calculator and show them how much a few hundred bucks a month can add up to over +20 years.
Hi My Money, Let me know if you need any help in the ebook department.
I’m somewhat obsessed with the compounding examples, probably because I’ve seen how they work in the real world-over time.
Great read, Barbara! Love the introduction to the Rule of 72. As a society, we perceive interest in two main ways: interest that is working for us, or interest that is working against us. As you mentioned, Albert Einstein claimed that interest is truly the eighth wonder of the world, “He who understands it earns it, he who doesn’t pays it”. Naturally everyone wants to partake in earning on his or her money.
However, in order to attain a true understanding of how to take advantage of compounding interest I think that there needs to be a shift of thinking on behalf of the everyday saver/investor.
Rate of return and interest rates are most thought about when purchasing a home, credit card or when investing money in mutual funds. People are concerned about the rate at which their money can earn interest, when they should be concerned with the volume of interest they can earn. While we continue obsessing ourselves with rates, banks smiles and laughs as he watches consumers barking up the wrong tree. Why else do you think a bank is willing to refinance your home at a lower rate? Because the volume of interest they will receive is going to far outweigh the adjustment to the rate on your mortgage. This misconception on behalf of the consumer was one of the contributing factors to the housing bubble and eventual economic crisis of 2008- this is a big deal.
I think that this is an extremely important factor when discussing compounding interest in a portfolio. Thanks for the great read!
Hi Will, Thanks for taking the time to weigh in on this important issue. That is exactly why I write about this issue, to help the consumer grasp that interest and rate of return is a concept, if utilized well trough investing can turn small contributions into a retirement or investment account into great wealth, over time.
I appreciate your input on the importance of understanding the “interest rate” concept.