Legend has it that Albert Einstein once described compound interest as the most powerful force in the universe. Whether or not he actually said it is open to debate, but the statement itself is largely true – at least in the world of investing. Why is compound interest so powerful? Because it accelerates the rate of growth of money in a supercharged way. Simple interest, on the other hand, doesn’t do this.
Compounding is based on the idea that the money you make off an investment can be reinvested to make even more money than your initial investment. The money you make goes back to work to make you even more money than before.
Sound confusing? It’s actually pretty simple.
Say you’ve invested $10,000 and it makes 10% interest per year. In the first year, you will earn $1,000 in interest. But in the second year, you’ll earn $1,100 (not only does your initial investment of $10,000 earn interest, but so does that $1,000 you made in the first year). In the tenth year, you’ll make $2,358 in interest. And in the 30th year you’ll earn $15,864. And the beauty of this is that you will earn all this extra money without making another investment beyond your initial $10,000. In 30 years, the power of compounding gets you from making $1,000/year to making $15,864 per year. That’s pretty cool.
You can magnify the results of compounding even further by doing regular investments. When it comes to building wealth the most effective strategy is to make regular and periodic investments and then let your money work for you, rather than spending it.
Following this simple rule can result in some surprising results. Take for example a man who decides to invest a portion of his income into an investment account of his choice every month and then commits to let that money ride. This means that he won’t make any withdrawals from this account until he has achieved his desired long-term goal. Let’s say he puts in $500 of his income every month.
Now, the overall market, as measured by the S&P 500 index, returned an interest of 11.8 per cent on average every year for the last ten years. Let us assume that you can achieve the same return and you can earn about $114,000 after the 10 year period. But technically it is much more than that. You will actually have $486,000 if you stick with your plan for 20 years and about $1.7 million in 30 years.
The process being described here is a combination of two very effective investing strategies that have proven time and again to achieve successful results: compounding and dollar cost averaging.
But let’s focus on compounding here. First, let’s define compounding. It is, in its simplest definition, reinvesting rather than spending your profits. By following this simple strategy you benefit from the future returns of your reinvest profits as well as on your original investment.
Compounding as an investment strategy is deceptively simple. But in reality it is fairly hard to do because you, as an investor, will need a lot discipline. The key, really, is to not touch your profits, but to let the magic of compounding work for you.
For any investor, seeing money build up in an account can be a big temptation. Many investors think that it won’t hurt if they skim off the profits and spend it on their whims since they won’t be touching the principal amount anyway. In reality, this won’t really hurt your investment position but, again, based on the concept of compounding, if you leave your money undisturbed in the account, the potential profits get exponentially larger.
Compound interest may not actually be the most powerful force in the universe, but when it comes to making money with your investments, it’s hard to beat.