Investing Basics – The Power of Compound Interest

 

The prior post about inflation discussed why savings alone can’t allow you to enjoy a comfortable retirement. The next set of posts will dive into different asset classes, but the first real question to ask is “How does investing combat inflation?” For those paying attention in the last post, it will likely come down to the power of compound interest. I mentioned that investing with a long time frame is essential and everything else will fall into place. If I could attribute one single factor to the success in reaching financial independence, it would definitely be understanding compound interest early on. I remember learning about it at 16 years old and became blown away by the concept. I immediately started saving $50/month from my work and let the power of compounding take effect. The effects of starting early are staggering. Don’t take my word for it – let’s look at some concrete examples. This will be the first post that relies heavily on numbers. For anyone interested in checking how these numbers are calculated, there are a bunch of compound interest calculators online with one of my favorites being Money Chimp.

 Scenario #1 – Investing Earlier is More Important than Sub-Optimal Investing

A) Janet starts investing at age 30 with $100K per year and gets 6% (general stock returns hover around 7-8% and let’s take away the management/financial planning fee of 2%)
She invests sub-optimally in mutual funds for 10 years before switching to index funds and getting the whole 8%/year. Jill has invested $1 million in total over 10 years.

B) Jill starts thinking about investing at age 30. She saved the same $100K per year but wanted to wait to really understand personal finance and “know” what to do with her money. Five years pass and by age 35 she has gained confidence in the right approach to investing. Jill takes her $500K she has saved and puts it into index funds that get 8% per year. Index funds generally mimic the broad market return they are structured to match with far less fees. I will cover indexing in great detail in future posts. She also continues to save $100K/year and put it into the market annually moving forward.

To summarize, Janet and Jill have invested the same total amount of money of $1 million each at the 10 year mark and $3.5 million by age 65. Jill gets a better return than Janet for the first $1 million invested but started investing later.

A) At age 65, Janet has $18.69 million
B) At age 65 Jill has $17.27 million
Despite investing the same total principal amount of $3.5 million each, the early investor reaps ~$1.35 million more in retirement savings.

 

Scenario #2 – Investing Early is More Important than Total Amount Invested

A) Let’s take Janet again who starts investing at 30 years old but can only save $50K/year and she gets 8%/year compounded annually. Total amount saved to age 65:

35 years x $50K/year =$1.75 million total saved

B) Jill enjoys a fun life for the first 10 years and starts saving twice the amount of Janet with $100K per year and does this for 25 years. Jill also gets 8%/year compounded annually as a return. Total amount saved by age 65:

25 years x $100,000/year = $2.5 million total saved

A)Janet ends up with $10.04 million
B) Jill ends up with $8.58 million
This difference is about $1.5 million more for Janet despite her saving $750,000 less just by starting 10 years earlier!

It is also interesting to look at Jill in Scenario #1 vs #2. By saving early and putting $1 million to work before the age of 40 in Scenario #1, “smart” Jill has more than double for retirement then “fun loving” Jill with a total difference of $8.689 million.

If we look at a new scenario with “even smarter” Jill who started off investing at 8%/year with $100K/year at age 30 instead of waiting till age 35, she has $20.09 million vs “smart” Jill with $17.27 million vs “fun loving” Jill with $8.58 million.

I want to make sure you are appreciating the mind-boggling results of 2-2.5x the final retirement nest egg by simply starting early and letting compounding do its work. Many readers are still within the age range to make this early start reap huge rewards for them. Really what compound interest comes down to is exponential doubling time. The scientists here will appreciate the beauty of embryonic cell division in both simplicity and speed. This is how life gets to millions of cells in such a short time.

Your retirement portfolio gets to millions of dollars via the same process, albeit at a much slower pace. Another great example of compounding is the story of the king, a chess board and grains of rice. Watch the first 1:30 sec of this clip for the description.

Clearly you will never get the opportunity to double your portfolio 64 times like the chess maker, but the concept is still powerful. The 2 key inputs for compounding to pay attention to are:

1) the interest/growth rate that is applied

2) the frequency that this interest/growth is compounded.

The below graph shows the effect of earning 20% annual interest on an initial $1,000 investment at various compounding frequencies:

When discussing investments, most often the term CAGR is used which stands for Compound Annual Growth Rate. Thus most investments are viewed with a yearly compounding frequency.

Most people think total amount invested and large investment growth is the key to wealth, but it simply isn’t true. The above scenarios have showed the length of compounding seems to be the most important variable for long term wealth accumulation (the x axis in our graph above). Our final scenario will look at the low to middle class small saver with an early start compared to the high income earner with better investment results but starting saving later.

Scenario #3 – Average Joe vs Rich Mitch

A) Joe learned the value of saving early from his parents. He had read some finance blogs like Mr Money Moustache that gave a blueprint for frugal living. He decided to quit school early at age 18 to work in the trades. He made about $17/hr or $35,000/ year. His early life had little costs with no dependants so he could save $1500/month or $18,000/year. As life went on, Joe increased his training with an improved hourly rate, but now had a family with more expenses. He could have tried to save more, but he let lifestyle catch up a bit like most people do. He decided to just keep investing the same $1500/month amount forever and felt secure his retirement would be safe. 50 years later, Joe has saved $900,000 total and earned a CAGR of 7% over 50 years after fees.

B) Mitch is a successful medical specialist that has studied hard and been in school a very long time, including some fellowship training. He finally began to work at the age of 35 with about $250,000 in debt. He earns a huge gross annual income of $440,000 and is left with about $330,000 after overhead expenses of 25%. Mitch thought about incorporating, but he has a young family with a new house and a large mortgage. He feels uncomfortable with so much debt and wants to prioritize paying it down. He needs to receive all his income personally to make the house and student debt payments along with his living expenses.

Mitch pays about 40% tax on the $330K personal income, which leaves him with around $200K after tax. He has a mortgage and housing costs around $5000/mth or $60K per year, and his family enjoys a nice doctor lifestyle spending $100K/year. He has around $40K/ year to pay off the $250K student loan/credit line off each year. After factoring in the extra $30-40K in interest over the life of the student credit line payment, he was able to be debt free in about 7 years.

Now that his big debt is done, Mitch is ready to invest by the age of 43. Let’s imagine he can now incorporate and defer some taxes by retaining income in his corporation. He now can save $100K/year on a tax deferred basis inside the corp and does so for 25 years to invest a total of $2.5 million by age 68 when he retires. He was pretty financially savvy and invested in indexes to enjoy an 8% CAGR over the life of his investments (1% more than Joe)

To summarize, Joe has invested $900K and Mitch has invested $2.5 million or  2.77x as much as Joe. Mitch also achieved 1% better overall on his investments than Joe. Joe’s only advantage is starting his compounding 25 years earlier. At age 68:

A) Joe has $7.32 million

B) Mitch has $7.31 million

If Joe had the same investment 8% returns as Mitch, his amount would be $10.33 million or 1.41x greater the amount of Mitch.

Starting early with proper saving behavior and basic investing is the number one factor for successful investing. There are numerous books that show financial freedom and wealth is attainable to any person with the right mindset.  Two of my favorite introductory books are The Wealthy Barber  or The Millionnaire Next Door . If you were to read either of these books, it would further strengthen your belief that maximizing savings and investing early is a guaranteed route to financial freedom.

Now that you understand the power of compound interest, it is important to revisit our enemy inflation and figure out what its compounding inputs look like. The first input of time frame allows inflation to have the upper hand. Inflation has no fixed timeline or lifespan for investment and therefore gets to double in perpetuity. It just keeps chugging along the generations. Our second input has the long term Canadian average of 3.87% inflation rate. At this “growth” rate, how long does it take inflation to double its cost of goods and services?

It turns out the answer is 18.5 years. Therefore, a $100K/year lifestyle will double twice over 37 years to cost an equivalent of $400K/year for the same lifestyle ($100K to $200K to $400K) To think of it in past tense, our parent’s lifestyle in 1980 of $30,000/year has doubled twice to cost $120K/year for our equivalent lifestyle in 2017. So now you can see inflation creates a doubling hurdle rate for our investments of 18.5 years or an annual growth rate of 3.87% just to keep our purchasing power of our hard earned dollars. The next post will begin reviewing the basic asset classes and the expected compounding rate of each.

Did the above scenarios surprise you? Do you have a good story about learning about compound interest? Has anyone experienced bad compounding from credit card debt? Please share your stories to help others learn from your successes or failures of compounding.

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3 comments On Investing Basics – The Power of Compound Interest

  • Excellent blog. I am looking forward to future posts.

    • Hi Christopher,

      Glad you are enjoying the posts so far. I’m curious if you found any of the compound interest examples surprising?
      Despite knowing the power of starting early, the average Joe vs Rich Mitch example caught me off guard when I first did the math. It saddens me how there is no basic financial education in high school when it could make such a difference

  • I agree. Excellent blog.

    The case examples are fascinating, as it is easy to defer savings in the event of some other life event (new baby, new house etc), however the effect of doing so is quite damaging long term. It is definitely a difficult balance to enjoy life now, while still preparing for the future.

    Thanks for the great post

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