Wednesday, May 13, 2009

The Magic of Compound Interest

"The most powerful force in the universe is compound interest."
Albert Einstein

Sometimes you have to step back and look at the big picture. Granted, if you're referring to the stock market, this isn't an easy task. The 24/7 news world we live in forces people to analyze, scrutinize and criticize things on a minute-by-minute basis. Several things though are best left for longer time horizons.

Often considered to be the 9th wonder of the world, compound interest is a magical concept. As defined, compound interest is the interest computed on the sum of an original principal and accrued interest. Very simply, it's the money you make on an investment over time!

For our purpose, we'll use the "Rule of 72" to illustrate. If an individual invests $10,000 and gets an annual return of 5% per year, it will take 14.4 years to double his/her money (72/annual return = amount of years required to double investment). Should the investment be more growth oriented and annualize at 8% per year, your time frame is reduced to 9 years. If we shoot for the stars and get 12% year over several years, you will require a mere 6 years to see your $10,000 investment grow to $20,000.

This concept works at any age, but the younger you are, the better. Recent college graduates make a good case study. They have a plethora of time and ample opportunity. Coming up with any type of lump sum is unlikely, but they can rely upon dollar-cost-averaging. Mutual funds will allow new investors to get started for as little as $100 per month. This may not sound like much, but let's take a closer look.

You can be a millionaire! Recent grads can rely upon employment income to come up with $100 per month. If he/she invests $100 per month at 10% per year for 44 years - a total of $42,800 - they will witness the magic of compound interest and watch their account value grow to $1,000,000 by the age of 65! Should their investment do a little better and make 12% per year on average, they will reach the million dollar mark at the age of 60!

The concept is very simple. The difficult part pertains to discipline. Having the courage & fortitude to stick with something for many years is challenging. There will be turbulent stock markets and investment gurus telling you when to sell & buy. As we should know by now, "It's time in the market, not timing the market" that prevails in the end.


ek said...

Compound interest is incompatible with industrial capitalism because the economy can't grow faster than financial claims

Parag said...

The younger you start retirement planning, the more years your money will have to take advantage of the powerful concept of compound interest.
What is compound interest
What is compound interest