Albert Einstein once called compounding interest the eighth wonder of the world. Obviously, Einstein was one of the greatest minds, so one should listen to what he says.
Compounding interest is one of the first concepts taught in finance 101. Your money makes money for you. How awesome is that!
Essentially, your money grows by a percentage over a month, quarter, or year. The new money you’ve made adds to your balance and grows at this same rate and the process repeats itself over time.
Time is a big determinant of success, so it behooves you to start ASAP. It can significantly change your financial well-being over the course of your working life. See the chart below as an example of investing $100,000 with various interest rates over the course of 30 years.
Back to the Basics – What is Compounding Interest?
Compound interest is “the interest on interest,” or the interest earned on your initial investment, accumulated year after year. The sooner your start, the better off you’ll be in the future.
The onus to utilize and implement compounding interest is put on individuals even more with the decline of employer pension plans and the rise of defined contribution plans such as 401ks. You must be proactive and disciplined with your savings and investing. It is not rocket science but it is a behavior in which a habit must be formed.
Applying The Concept of Compounding Interest
This topic has been discussed ad nauseam but I think compounding interest in relation to the non-financial areas in your life is less discussed, at least among financial professionals. The concept of compounding interest can be applied to other areas such as hobbies, relationships, skills, and business. For example, exercise takes changes in lifestyle, diet, fitness, and consistency to make progress over a period of months and years.
Growing a business and acquiring new customers can be looked at in a similar way. Over time, enough calls and meetings are conducted with each one building upon one another. This eventually leads to critical mass in the sense that you begin getting customers or sales on a consistent basis. In turn, there are more opportunities available either by getting introduced to more profitable markets or bigger clients.
The point being, your actions build on each other. The most difficult part is almost always the beginning in the first few years. In order to gain enough positive momentum in which you can see major change and results, it will take time. This includes health, business, and investing.
If you change your mindset and take a long-term view of your daily activities in these areas, your actions and outlook can change. It is not easy by any means but I think recognizing this will provide some peace of mind and positivity. “Don’t lose sight of the forest for the trees” – something I think we’re all guilty of, especially when dealing with complex problems or goals that are so far out in the future, such as saving for retirement.
It can be extremely frustrating when you’re not seeing quick results from anything you work hard at. This can be applied to building wealth and investing since it usually takes multiple decades to create a legacy and to achieve financial independence.
The chart above shows different interest rates with an assumed annual savings rate of $15,000 to show you simple projections of compounding. I used $15,000 as an annual savings figure on the assumption that a household is earning $100k a year in gross income and saving 15% of their income for illustrative purposes.
Your First Million is the Hardest
Let me explain what I mean by this statement. It may seem self-explanatory, but I’m talking about reaching your first million dollars in investable assets.
This achievement depends on a lot of variables but the three main ones are:
- Your capacity to save, actually saving and subsequently investing in the markets
- Actual market returns over time
- The amount of time you have available to invest
Typically, someone’s biggest determinant of success is their ability to save money and keep expenses low. This is to live within your means. So boring, I know, but it’s the truth and basic math. Compounding interest at it’s finest.
I’ve included a graph below for reference. Basically, I like to break down a 10% return on the various dollar amount milestones of an investment portfolio. For example, we can use $100, $1,000, $10,000, $100,000, $250,000, $500,000, $750,000, and $1,000,000 to illustrate the impact of return rates. See my spreadsheet below for a visual.
My whole point is that market returns, which I’m using an 10% as an example, matter much less in the beginning of your journey. A ten percent return on a $10,000 portfolio vs. a $100,000 portfolio is $1,000 Vs. $10,000.
As stated earlier, your savings rate will be the determining factor in the balance of your portfolio. It will likely be eclipsing any returns the market will provide early on. As time goes by and your balances grow so does the impact of compounding interest. Once you hit $1 million now a 10% rate of return will provide you with $100,000 which will continue to compound year over year.
Once you’ve hit this $1 million mark you have the wind to your back! It makes it a lot easier to build wealth and reach financial independence.
Now all of a sudden market returns are rivaling your annual income. It is now much more material than when you first started. The hardest part is having the discipline and foresight to get there. See the spreadsheet below for a visual.
My objective with this example is to show the difference in dollar returns on various account balances. As you can see, the dollar return capturing a 10% jump in the market on the lower account balances is not nearly as a material of a difference than the higher balances.
This may seem obvious but my point here is to show the difference between smaller and larger balances, what it takes to get there, and the potential benefits.
Be Disciplined and Stay Consistent
This saying goes for all the things in your life that require consistent effort.
Think about it: your income grows over time, your relationships grow better over time, and you refine skills and learning over time all with a concerted and consistent effort.
That is the impact of compounding in life and finance. The flip side is that It can work against you if you don’t do anything you will stay stuck and most likely atrophy. It takes WORK and TIME.
I believe the sooner one accepts this and gets comfortable with the concept the better they will be. Even those with great wealth have slowly built it by working hard and putting themselves in a position to capture better opportunities.
As the saying goes, “luck is when preparation meets opportunity.” Clients and customers can get larger over time but you have to put the work in to be able to get the opportunities. The same is true with saving and putting yourself in a position to capture the upside of markets.
Numbers get bigger with less effort over time in the sense that your efforts and resources have compounded and are now working harder for you. This can apply to business capital and relationship capital. It could take years to get in front of a massive customer or come up with the right product at the right time. All of a sudden there is a shift and you are able to capitalize on the opportunity.
The most important thing is what you are doing in the meantime. How you are managing your behavior and risk to put yourself in a better position tomorrow? Allow your future self to take advantage of all the daily small steps. Compound your steps in the right direction.
Trying to find a quick fix is typically a fool’s errand. It can be done and does happen from time to time but it is much more a matter of blind luck and high risk, such as gambling. You’re smarter than that. My point is to do good things, be productive, be consistent, and understand that good things take time.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
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