FINANCIAL FRESHMAN #061
TL;DR → Investors like Warren Buffett draw attention for their investing abilities, but the real secret to their success is time and compound interest. By having your money invested in a diversified portfolio and leaving it untouched, the everyday investor can reap the same rewards.
Compound Interest Growth
Compound interest is remarkably powerful. So powerful, in fact, that Albert Einstein once had this to (allegedly?) say about it:
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Anyone that has grown a significant retirement nest egg or struggled to pay off a credit card bill can attest to the truth in this statement. If you want to reach a place of financial independence, one where your assets can pay your bills for the rest of your life, you will certainly need compound interest to help you get there.
This topic is so important that I wanted to spend this week talking about it. By the end of this post, you’ll understand what compound interest is, how to calculate it, and how to make it work for your finances.
(You like quotes about personal finance like the one we shared? We share one every Friday on our LinkedIn page).
Compound vs. Simple Interest
Simple interest is…simple. You make a deposit of $1,000, and you earn fixed interest on it for the foreseeable future. When interest compounds, you earn interest not only this same principal investment, but also any additional interest your money has already earned. Instead of growing in a straight line, your money starts to grow like a snowball rolling downhill—picking up more and more along the way.
It’s just math, so there’s no need to convince you that compound interest builds wealth. What’s harder to grasp is just how powerful its impact really is.
Confounding Compounding
A few times on this blog, I’ve plugged the book The Psychology of Money by Morgan Housel. Chapter 4 of this book is titled “Confounding Compounding,” and it explores this exact topic. You know that compound interest working in your favor is a good thing, but do you really understand how impressive compound growth can be?
In this chapter, Housel spends a good amount of time talking about Warren Buffet, and he uses him to take the reader through a few thought exercises.
As I read (and re-read) through these thought exercises, here are the parts that jumped off the page to me:
- When this book came out (in 2020), Buffett was 89 years old, and had a net worth of $84.5 billion. $81.5 billion of that came after his 65th birthday. His net worth as of this writing is $146.2 billion, to save you a Google.
- Buffett is a very skilled investor, and saw 22% average annual returns over the course of his investing career. He also famously began investing when he was about 10 years old. What if he started at 30? Well, his net worth would have been $11.9 million instead of $84.5 billion.
- Have you ever heard of the late Jim Simons? He was the head of the hedge fund Renaissance Technologies, which saw an average annual return of 66% between 1988 and 2020. This is triple the return that Buffett saw, but it started when Simons was already 50 years old. Despite the unbelievable return, Simons only had 25% of the net worth of Buffett.
- For fun, Housel also highlights that, had Simons began investing the same year that Buffet did, his net worth would have been $63 quintillion dollars.
He uses all of these points to highlight the value of time in the market. Housel paints a convincing picture that Buffett’s investing acumen didn’t do nearly as much of the heavy lifting as his patience did.
“His skill is investing, but his secret is time.”
That’s great news for everyday investors like you and me. We don’t have Buffett’s skill, but if you’re early in your adulthood, time is most certainly on your side.
Learning the Math
Don’t freak out, because this may start looking like math class. Below is the formula to calculate compound interest:
Let’s define each of these variables, and then run through a quick example.
- “A” refers to the future value of our investment
- “P” refers to the starting principal balance of our investment
- “r” is our annual interest rate, expressed as a decimal
- “n” is the number of times our interest compounds per period “t”
- “t” is the amount of time, typically in years
Let’s use this formula to calculate the future value of a $10,000 investment. Assume that we’re earning 8% interest, that interest compounds every day, and our money is parked in this asset for 20 years in total. Plugging in those numbers, below is what we would get. Remember your PEMDAS!
As you can see, our hypothetical $10,000 investment would earn an additional $40,000 in compound interest over these 20 years. And remember, this is without adding any additional funds! Just parking money and being patient.
Sound too good to be true? It’s certainly not—let’s wrap up by covering some best-practices to make compound interest work in your favor.
How to Take Advantage
Targeted to the college student or recent graduate, here are some ways to best take advantage of compound interest:
- Start Early – One of the biggest mistakes you can make is to to forego investing a small amount because you think it’s not enough. Any amount of money will significantly benefit from being exposed to the market for a long period of time.
- Stay Consistent – When you make your budget every month, treat investing or saving just like you treat your monthly bills.
- Let it Grow – As you watch compound interest work its magic, it can be tempting to interrupt the progress to fund a big expense like a home. Remember that you’d be resetting the compound interest timeline if you were to withdraw money. Because of this, you should never invest funds that you need to spend in the near-term!
- Pick the Right Accounts – IRAs, 401(k)s, HYSAs, and index funds are all great ways to reap compound interest rewards.
Final Thoughts
Remember that the key isn’t finding the perfect investment, but rather giving your money time to grow. Compound interest works best when you start early, stay consistent, and allow your money to remain in the game. Over the years, even small amounts of money can turn into significant wealth if you simply let time do the work.
