Key Points:
- Start Early and Stay Consistent
- Minimize Costs to Maximize Returns
- Compounding in all Facets of Life
The quote often attributed to Einstein says “compound interest is the 8th wonder of the world, those who understand it, earn it, those who don’t, pay it.” This captures the profound power of compound interest. The bottom line is whether you, as an individual, are managing debt or investing to earn your way to Financial Freedom, the principle of compounding works like gravity, always pulling either toward growth or greater burden. In essence, compounding is misunderstood by most people, often perceived as some nebulous concept far out of reach. Yet, the key is to start small and build on the compound effect over time. To provide a concrete example, let’s say you started investing $200 per month, then in 10 years at 20% compounded, you can expect to have $67,830.05. The bottom line is that is real money that anyone with $200 to set aside for investment each month can very reasonably attain!
Starting very early in compounding makes a massive difference that cannot be understated. As an example, we mentioned previously that by investing $200 per month in 10 years at 20% compounded, you can expect to have $67,830.05. By investing $200 per month in 10 years at 21% compounded, you can expect to have $71,547.41.
What is more interesting is that investing $200 per month at 20% compounded for 20 years yields $487,809.62 whereas investing $200 per month at 21% compounded for 20 years yields $552,875.90. In other words, the difference over 20 years from a 1% increase of $552,875.90-$487,809.62=$65,066.28 difference versus just $3,717.36 over 10 years. These numbers illustrate that each additional compounds your money much more by each incremental return. Thus, the best game to play for wealth building is the compounding game. With each additional year, the compounding becomes much more & more. Hence, it is very important to start early to benefit from the dramatic effects of compounding in the latter years.
The Real Cost of Waiting
Delving into the cost of waiting shows how not investing early can penalize you. For instance, take Sarah, a recent college graduate who started investing $500 per month in her IRA at the age of 24. Assuming an average annual return of 7%, by the time Sarah reaches 65, her investments could potentially grow to over $1.5 million.
Now, let’s take Emily who realizes the importance of investing for her future and begins contributing $500 per month to her IRA. However, starting at 40 means Emily has fewer years of compounding ahead. By age 65, her investments may grow to approximately $380,000. Although Emily is still benefiting from compound interest, her nest egg is considerably smaller. The effective opportunity cost is $1.12 million. By starting later, the opportunity to grow exponentially and benefit from compound interest declines. This can be viewed as a real cost in the sense that it is money left on the table by not starting earlier, a cost that makes a meaningful difference over time.
How to Maximize Your Compounding Potential
Pick the Best: To avoid such costs, it is important to consider all investing options but ultimately pick the best options. The difference between the best and the rest compounds over time in terms of investment options out there. Standard platforms will charge traditional fees while indexing to a benchmark such as the S&P 500. What this does is implicitly guarantee you underperformance (index return minus a platform fee).
Thus, to compound at higher rates, first, it is important to reinvest returns back into investments earning high returns. Warren Buffet mentioned that a dollar invested should generate more than $1 in returns. This should be the de facto test for reinvesting.
Avoid High Fees: One must avoid higher management fees, platform fees, and even ETF fees that charge expense ratios and, in some cases, additional fees such as no-load fees, etc. The incremental management fees take away from the compounding and if the fees operate as a percentage of AUM, then the fees rise with higher assets under management. In effect, this penalizes the user for adding more dollars for investment through traditional platforms.
Stay Consistent: Just to provide a concrete numerical example, investing $200/month for 20 years at a 20% annual return will yield $632,295.87, however, if you skip the first 5 years of investing and invest for only the subsequent 15 years at a 20% annual return, then the total future value is $226,858.98. By skipping the first 5 years, you lose $405,436.89 in compounded returns. This stark difference highlights the importance of consistent investing over time as well as staying consistent and Start Investing Early to allow the laws of compound interest to work their magic!
Compounding Beyond Money
The chains of habit are too light to be felt until they are too heavy to be broken. This truth of life is a reality that everyone must face at some point. Some realize it sooner; others realize it later. Nonetheless, everyone must face their reality at some point. One of the key tenets of life is that compounding impacts every facet of life from training for sports to caloric intake to intelligence and beyond. If you would like to improve in life, compounding is the engine of growth for such improvements, whether in investing or otherwise.