Disclaimer: This post is not investment advice – details are use merely to illustrate a general investment principle.
I don’t use the word miracle lightly, but tell me: does turning $10,000 into $452,593 without putting in a single extra dime not sound like a miracle? Well hang onto your hats, because one powerful phenomenon can make this miracle a reality: compound interest. Let’s do a bit of maths:
Captain Thrifty starts with $10,000. He puts it into a fund which tracks the S&P 500 (don’t worry about it if you haven’t heard of this – it’s basically just a vehicle to invest in all of the biggest US companies at the same time). Captain Thrifty gets a 10% return (historical records show the average annual return for the S&P 500 since it began in 1928 is approximately 10%) = $1000. His $10,000 is now $11,000.
Captain Thrifty gets another 10% return = $1100 (10% of $11,000 rather than the 10% of $10,000 he got in Year 2). His $11,000 is now $12,100.
So far, so pedestrian. Lets have a look what happens over the rest of a 40 year working lifetime, though, at that 10% return:
Year 10 $25,937
Year 20 $67,275
Year 30 $174,494
Year 40 $452,593
Putting in no more money, that initial investment has grown more than 45x over. Sound exciting? Damn right it does. You’ll notice a few things:
- Time is the magic ingredient. Compound interest starts off slow and unsexy, but by Year 40 that original $10,000 generates over $41,000 in a single year!
- Winners start early. Because time is so important to harnessing the power of compound interest, the earlier you start, the more heavy lifting it can do for you.
Before we all get too excited, though, there are a few important things to be aware of:
- Inflation. The calculations above don’t take account of inflation. You may have 45x the nominal value of your starting sum, but that doesn’t mean it’s worth 45x that sum in today’s money. Generally speaking, we’d expect everything to be much more expensive in 40 years’ time, so your money won’t go as far. Accounting for inflation, the S&P 500 has returned around 7% per year. At 7%, $10,000 in todays money would become $149,745. Still not shabby!
- Returns. The 10% figure is based on historical returns. However, it’s very debateable whether or not similar returns are likely for the next 100 years. The return you get will affect the final outcome massively.
- Volatility. Returns are not consistent in real life. This massively affects the final outcome. Take this example. Two annual returns of 10% each make for an average annual return of 10%. So does -10%/+30% or -20%/+40%. Should end up with the same result then…nope!:
- $10,000 -> +10% = $11,000 -> +10% = $12,100
- $10,000 -> -10% = $9,000 -> +30% = $11,700
- $10,000 -> -20% = $8,000 -> +40% = $11,200
The long and short of it is that we can’t go too crazy with our figues, but still let’s be honest – compound interest is a powerful tool towards Financial Independence. If you’re a young reader, especially, time is on your side. Get that snowball rolling and it just might surprise you. And even if you’re a little older, don’t worry. This can still help you. After all:
The best time to plant a tree was 20 years ago. The second best time is now. – Chinese Proverb
What’s the most powerful financial concept you know? Do you like to crunch the numbers or play everything by ear?