Compound interest is often referred to as the eighth wonder of the world. Simply put, compound interest refers to interest on interest. When you save money, it can be loaned out and earns a certain percentage of interest every year. That interest earned can then be loaned out and earn even more interest on itself.
Taking it a step further, compound returns are simply returns on returns. Any money saved or invested can earn a return, whether it be from interest when that money is loaned out or from other avenues, such as profits from owning equity in a business.
When someone saves and invests their hard-earned money, they obviously hope that it earns them more money. As this happens, that new money can be reinvested and earn even more money, and that cycle continues. All of this seems simple and obvious, but when you look at compounded returns over time, you will find some unbelievable results, especially when you start early.
To illustrate this point, the following example focuses on two people who want to start investing, Megan and Jeffrey.
Megan just turned 25 years old. She has some money saved, and she decides to begin investing it in the stock market. On her 25th birthday, she invests $4,000, and then invests another $4,000 every year for the next 9 years after that. By her 34th birthday, she has invested a total of $40,000. She pats herself on the back and decides not to add any more money. She just lets the money that she already invested earn returns and compound.
Jeffrey also recently turned 25. He considers his option to start investing, but for whatever reason, decides to put it off. When he turns 35, he finally figures that it is time. He invests $4,000 and continues to invest the same amount every year for the next 3 decades. By his 64th birthday, he has invested a total of $120,000. At that point, he also stops making contributions.
Upon turning 65, they each decide that they want to retire. They both earned a generous return of 10 percent per year, compounded annually, and are excited to see how much they ended up with.
Megan ends up with a total of $1,223,623. After investing only $40,000, she is absolutely amazed by how her money has grown over the years. Every dollar essentially multiplied 30 times.
Jeffrey ends up with a total of $723,773. He is also incredibly happy considering he only invested $120,000. Every dollar multiplied about 6 times.
The chart below represents their gains over the years.
They both deserve to be ecstatic. After all, owning a piece of the global economy has paid off big for both of them. On the other hand, the results may seem a little bit surprising. Megan invested a third of what Jeffrey invested ($40,000 vs. $120,000), while receiving the same rate of return (10% per year); however, she ended up earning nearly $500,000 more than him over the years. How could this be possible?
By beginning a decade earlier, Megan gave her money more time to grow, and was greatly rewarded for it.
It is important to note that the market is volatile, and a consistent exact 10% return every year is purely hypothetical for this example. It does, however, clearly show that investing money as early as possible gives it the most time to grow via compound returns.
Whether you are older or younger than Megan in our example, the sooner you start, the more time your money has to potentially grow. However, many people find excuses to put it off.
You may not have much money to invest right away. Luckily, it has never been easier to begin investing with a very small amount of money. Investing can not only lead to large returns, but it can also be a very empowering experience. After all, the stock market is the most passive wealth builder in the world. It can give you the power to stop trading your time for money, and that allows people to spend their time doing whatever they want.
Maybe you want to spend more time with your family and less time at the office.
Maybe you want to travel and see the world.
Maybe you want to start a business, or write a book, learn to cook, go dancing in the rain.
Whatever you want to do, you can build something to help you get there. Building toward your goals can, and absolutely should, make you feel good!
With that in mind, a lot of people want to invest, but they just don’t know where to start. There are many people and applications out there that will invest your money for you. However, they charge fees that compound over time, and that can eat away at returns. In addition to that, by giving your money to someone else, you may be relinquishing a lot of control. By contrast, there are many do-it-yourself online trading platforms. These allow you to buy and sell stocks on your own. Unfortunately, they can be hard for novice investors to wrap their heads around which often leads to poor results. Some people look at their trading apps as a miniature casino in their pocket, and they ignore the power it can provide. The following articles are designed to teach some of the basics of the stock market. By reading them, you can add to your understanding of how it all works and how you can make it work for you.
Key Takeaway: Although you can always find reasons to not save and invest, starting early can give your money the most time to benefit from compound returns. Getting started, no matter how modest in the beginning, can be the first step toward achieving your goal.