Understanding compound interest is really hard because our brains aren’t designed to comprehend it well. But if people truly understood compound interest, they would stop looking for the get rich quick scheme and start investing earlier.
Want to know something crazy… Of Warren Buffett’s $84.5 billion net worth, $84.2 billion was accumulated after his 50th birthday. Why? Because of compound interest. Compound interest is so powerful that Albert Einstein once said “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Why is it so powerful?
Let’s look at compound interest from a few different ways to help you better understand it.
1. An Example With Math and Investing
Brittney is 20 years old and decides that she is going to invest $10,000 she was given into the S&P 500. And she promises that she will not touch this money again until she is 70.
How much money do you think she will have at 70?
Let’s take a look using an 8% return.
At 30, she will have $21,590
At 40, she will have $46,609
At 50, she will have $100,626
At 60, she will have $217,245
At 70, she will have $469,016
Over 50 years, if she doesn’t touch that $10,000, it will grow to $469,016… Think about that. That is a 46x multiple assuming an 8% return over 50 years. And of that $459,000 of growth, $242,000 of it comes in the last 10 years.
Now let’s look at what Sarah would have if she decided she could hold onto it for 10 more years. At age 80, she would have $1,012,570. If she held for 50 years, her $10,000 investment would grow to over $1 million. And over $550,000 of that would come in the last 10 years.
See compound interest is so hard to understand and wait for because almost all of the growth comes in the last few years.
Now let’s look at the numbers if she decided to do the same thing, but also contribute another $6,000 a year (The ROTH IRA maximum) over this time frame.
At 30, she will have $108,508 ($70k of contributions)
At 40, she will have $321,181 ($130k of contributions)
At 50, she will have $780,325 ($190k of contributions)
At 60, she will have $1,771,584 ($250k of contributions)
At 70, she will have $3,911,637 ($210k of contributions)
Talk about some insane growth. This time, at 70, she ends up with $3,911,637 and only had to contribute $210,000 to get there. But if she stopped 10 years earlier she would have $2.2 million less. See the biggest growth comes in the latest years. This should help you realize that you need to start investing now!
2. Let’s look at an example non math wise (s/o @morganhousel for using this on his podcast with @TimFerrissShow)
There is this old riddle about a lily pay in a pond.
If the lily pad doubles in size everyday and after 30 days it fully covers the pond, on what day does the lily pad cover half the pond? If you guessed day 15, you are wrong. But this is how our minds work, since we think linearly. The pond surprisingly would be 50% covered on day 29.
So how covered would it be on day 15? This is shocking to most people. It would be covered .0031% on day 15. The lily pad wouldn’t even cover 1% of the pond until day 24…
Insane right? The lily pads growth is exponential not linear, just like compound interest is. Our minds do not comprehend this idea well because the math is way tougher. But both these examples should help reinforce in your mind the power of compound interest. In this example, it took 29 days to get to 50% and then 1 day to get the last 50%.
“Once you accept that compounding is where the magic happens, and realize how critical time is to compounding, the most important question to answer as an investor is not, “How can I earn the highest returns?” It’s, “What are the best returns I can sustain for the longest period of time? That’s how you maximize wealth.” – Morgan Housel
Takeaways from this:
- Let compound interest do it’s work
- The worst thing you can do is stop compounding interest. So you should design your finances in a way where you never have to sell and stop this from occurring
- The biggest gains by large come in the latest years
Start investing today!