What has been called the most powerful force in the universe, the eighth wonder of the world, and one of the greatest discoveries of our time? No, it's not Rich Money Million - but good guess! It's actually the concept of compounding interest, which can turn a little bit of money, invested well over time, into a fortune.
The easiest way to understand how it works is to imagine a snowball. If you stand at the top of a hill and roll a marble-sized snowball down the slope, as it travels on its journey to the bottom it picks up more and more snow, slowing increasing it's overall volume, and eventually gets so big that it sends punk snowboarders fleeing in fear.
When you save or invest and your money is compounded annually, in the first year you earn interest on the original principal. In the second year you earn interest on the original principal as well as the interest from the first year. In the third year you earn interest on the original principal, as well as the interest from the first two years. And so on. Even at a modest interest rate, given enough time, an unremarkable sum of money can grow to a staggering size.
For example, if you saved $10 a day (about the cost of a fast food meal) and used the money to purchase shares once a year in an investment that offered a modest rate of return (the market average has been about 12% for the last hundred years or so, even counting the crashes of 1929 and 1987), and allowed all your profit to be re-invested (adding your interest to your prinical), after 30 years you would have invested a total of $54,750 and would have a balance of over $1.9 million! If you were smart enough to purchase shares in an investment that offered higher rates of return, you would do even better. With the same figures, but at 15% return you'd end up with over $4.4 million!
Try out this great Compound Interest Calculator, from the National Council on Economic Education. It allows you to experiment with different variables for amount invested, time invested, and rate of return.
To take full advantage of compounding interest, there are three rules to remember:
Start early
With compounding interest, your best friend is time. Start rolling your snowball at the top of the hill and you'll have a much bigger mass at the bottom than someone who started halfway down. Even if you invest for a few years in the beginning then stopped, allowing interest to earn only on what has been invested thus far, you can still walk away a big winner. This point is illustrated in a (paraphrased) example from a book called The Random Walk Guide to Investing by Burton Malkiel.
The answer is that William has $1,365,227 while James has $218,364. James invested 25% more than William, but through the magic of compounded returns, William’s IRA fund is worth more than six times as much!William and James are twin brothers who are 65 years old. 45 years ago (at the end of the year when he reached 20), William started an IRA and put $2K in the account at the end of each year. After 20 years of contributions, William stopped making new deposits but left the accumulated contributions in the IRA fund. The fund produced returns of 10% per year tax-free. James started his own IRA when he reached the age of 40 (just after William quit) and contributed $2K per year for 25 years, making his last contribution when he turned 65. James invested 25% more money in total than William. James also earned 10% on his investments tax-free. What are the values of William’s and James’s IRA funds today?
A little goes a long way
In another article I wrote about how saving pennies can add up to hundreds of dollars. Remember that a bucket of water is filled drop by drop, and you don't necessarily need to have thousands of dollars to start investing. If you started when you were twenty years old and saved $50 a month (less than $2 per day) to purchase shares in an investment earning 10% per year, at age sixty-five your investment of $27,000 would have grown to $528,000!
A little change (pun intended) can make a difference elsewhere in compounding, as well. For instance, if that same investment earned 9% annually instead of 10%, you would end up with $373,000 in the same period of time - a difference of $155,000. The lesson is that it's much better to start investing when you're young, and to do so aggressively in the beginning. If you are relatively young and have several decades before retirement, you should invest as much as possible in stocks or mutual funds (I prefer the latter) and avoid bonds and other conservative investments.
A little change (pun intended) can make a difference elsewhere in compounding, as well. For instance, if that same investment earned 9% annually instead of 10%, you would end up with $373,000 in the same period of time - a difference of $155,000. The lesson is that it's much better to start investing when you're young, and to do so aggressively in the beginning. If you are relatively young and have several decades before retirement, you should invest as much as possible in stocks or mutual funds (I prefer the latter) and avoid bonds and other conservative investments.
Get it and forget it
There are some investors who have to check the stock ticker every hour and reallocate their investments every week based on what's happening in economics, politics, and even the weather. This is time-consuming, stressful, and is generally not a good practice. It's much more reasonable to pick your investments wisely, and then stick with them for some time. Being steady and patient is one of the cornerstones of Warren Buffet's own investment philosophy.
It can be excruciating at first, as you monitor the growth of your investment, as it will grow very, very slowly in the beginning. There's no exciting, dramatic, double-your-money-in-six-months scenario. But you have to remember that for compounding to work its awesome power, time is the magic ingredient. As your money earns more, it grows and earns even more and more.
0 Comments:
Post a Comment