What is compound interest? | Invest

When it comes to investing, compound interest is truly the most powerful force in the universe. Remarkable for its simplicity and power, compound interest is the concept of reinvestment, along with the initial capital, the interest earned on your investment.

As a result, you earn interest on top of interest, then more and more of that larger amount, and so on. “Over time, a small amount of money can turn into a mountain of money,” says David Winters, CEO of Wintergreen Advisers.

Compound interest is one of the most basic concepts for investors to understand, largely because its magical results work the same whether you have $ 100 million or $ 100 million.

In that sense, it’s any investor’s secret weapon – and you’ll probably want to use your secret weapon if it can help you build your retirement nest egg (which it can). Unfortunately, if you look at how the average American spends and invests, it doesn’t reflect a great respect or understanding of compound interest.

It is time to change that.

Demonstrate its power in a thought experiment. David Reiss, a law professor at Brooklyn Law School, likes to convey the deep power of compound interest with a sort of conundrum.

“Would you rather receive a gift on January 1 of $ 1 million, or a dime that doubles every day for the rest of the month?” said Reiss. “Most kids would go for the million dollars, but those who are patient enough to do the math know they can get millions more if they are patient enough to wait the month.”

It’s true. The voice actor would actually end January with $ 9.7 million more than his instant gratification friend.

The rule of 72. Using a trick, the Rule of 72, you can figure out how many years it will take you to double your money, assuming a certain rate of return. Simply divide 72 by your expected annual rate of return and you will have your answer.

Therefore, if you plan to earn 10% interest on your investment, it will take you around 7.2 years to double your money. (In practice, this will take 7.3 years). It can also show the power of compound interest; if you weren’t reinvesting the interest every year, it would take you 10 years to double your money to a 10% rate of return.

Practical implications: start investing early. Even more interesting than the math is the practical implications for investors. One of the most important takeaways is the idea that you should start investing early.

Starting early has a huge impact when you leave your returns on your investment. Consider someone who raised a nest egg of $ 10,000 on the stock market at the age of 25. If he never pays another dime in his life and the market is gaining 8% per year, he will retire at 65 with $ 217,245.21.

If, however, a 35-year-old starts saving with $ 10,000 in the stock market, they will only become $ 100,626.57 when they retire.

“The most important investment decision a person makes is the decision to start,” says Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pa. “Time is an investor’s greatest ally, because time allows people to compose.”

Could people be a little more careful when it comes to savings if they keep this concept in mind forever? It’s hard to imagine that the answer is “no”.

Fees eat away at returns over time. Another takeaway from realizing the power of compound interest is that fees – on exchange traded funds, mutual funds, fund managers, etc. – cost you much more than the costs themselves. This money could have been reinvested in the market and turned into a small fortune.

At a 10% rate of return over 50 years, $ 10,000 turns into $ 750,025.36 if you assume your manager charges an annual fee of 0.9%. The same investment at the same rate of return but with a fee of 0.05% – some Vanguard index funds offer low rates like these – would turn into $ 1,144,931.78.

That’s a difference of about $ 400,000. With that in mind, investors should really keep a close eye on the expense ratios and management fees they pay to the people and institutions that manage their money.

“High fees over many years can really reduce your income,” says Reiss. No kidding.

Pay off your credit cards. Would you want a force as powerful as compound interest to work against you? The answer is clearly no, but several million Americans still have large unpaid balances on their credit cards. Compound interest is the reason why many remain perpetually in debt because of these bills.

Mastercard (ticker: MA), Visa (V), American Express (AXP) – these are businesses that traffic and take advantage of the magical ability of interest to come up with remarkable results.

It’s no coincidence that one of Warren Buffett’s biggest investments is AXP – it’s a way for him to bet more money on compound interest, the concept that takes Wall Street to the sky.

It’s time to use it. Compound interest is precisely how Buffett became a billionaire to begin with, and how he has managed to be on the list of the richest people on the planet indefinitely for decades now. If you had invested $ 10,000 in Berkshire Hathaway (BRK.A, BRK.B) in 1965 and let it roll, it would be worth $ 197.27 million today.

But luckily, you don’t have to work with large sums of money for this to work – anyone can use it to their advantage.

Using this secret weapon that we are all equipped with truly has the potential to solve the financial anxieties of millions of people, if only they practiced a little more patience and discipline.

It’s not easy to put money every month into a low-cost index fund that you can’t touch for decades, and depriving yourself of the flat screen TV you crave is easier said than done. to do. But if you want to use your secret weapon to achieve your financial dreams, all you need to do is read the instruction manual.