The Miracle of Compound Interest

Your Most Powerful Investment Ally is Time

If you’ve ever heard compound interest described as “the most powerful force in the universe,” it’s probably on account of a quote to that effect attributed to Albert Einstein. As it happens, the quote itself is probably an urban legend. But if Einstein didn’t make such a reference, (or, as an alternative version has it, call compound interest “the most important invention of all time,”) it was probably because he was too busy with E=MC2 to give the matter much thought.

E=MC2 is the formula that describes converting mass into energy. Compound interest, by contrast, is the formula that describes converting time into money. Lots and lots of money.

Compounding Turns Time Into Money

Put a penny in the bank. Then, every day, double the amount of your balance. Two cents. Four cents. Et cetera. After 31 days, you’ll have more than $21 million! Because with compound interest, the interest is immediately added to the principal, and then the new interest payment is applied to the resulting sum.

The 31 day example assumes a daily interest rate of 100%, and that is not something normally encountered in the real world. But compound interest can nonetheless lead to staggering results even with the sorts of returns long familiar to investors — as long as you give it enough time.

Let’s use a more realistic example. Say you were to start a lifelong habit of putting 15% of your salary into a brokerage account as soon as you begin your first job. We’ll further assume that your initial salary is $50,000, and your salary will grow at an average annual rate of 4%. You’ll invest your savings in a moderate risk diversified portfolio, which will earn 5% annually. After a few decades, your compound interest-enabled wealth would be eye-popping.

You’d have roughly $1.8 million after 40 years. Give it another 10 years, and your balance would shoot up to $3.3 million.

Change the rate of return, and the numbers become even more dramatic. At 10%, for example, you’ll end up with $5 million after 40 years, and almost $14 million after 50!

A time period of 40 and 50 years might seem extreme, but for a young professional in her 20s and 30s this might be a very realistic time frame. Every decade matters. The massive end result difference between 40 and 50 years of saving vividly demonstrates a stark reality about compound interest: The single most important thing you can do is to start early. Put another way, when you start saving is more important than how much you save.

The Earlier You Start, The Further Your Dollars Go

Consider two different savers, one who starts at age 25, the other at age 35. Even if they both save the same amount, the one who starts younger will have twice the savings by the time both reach 65.

Another way of looking at the same issue: If you want to retire a millionaire, you need to save just $493.48 a month if you start when you’re 25, assuming a 5% return. But wait until you’re 40, and the amount zooms up to $1,201.55. In fact, a 50 year old has to save more than 2x the amount a 40 year old needs to save, just to hit the same goal of $1 million at retirement.

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Time is Your Biggest Ally

Young professionals have a huge advantage compared to older investors, because they have time.  You can never get it back, but the sooner you begin saving, the sooner compound interest can start magnifying your results.

Too many young investors get discouraged after just a few years of saving, because those time periods are too short to see a significant benefit from compounding. But over decades, the benefits are tremendous, even at relatively low rates.

You just need to remember three things.

  1. Start early.
  2. Be consistent.
  3. Leave your money alone.

Pretty simple stuff. Albert Einstein couldn’t possibly disagree.

Disclosure

The information contained in this article is provided for general informational and educational purposes. Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.


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