With today’s article I would like to talk about the power of compound interest. Since interest rates are currently at a record low, obviously this is not a common topic to talk about anymore. With investment products, like life insurances or a classical savings accounts, it is nearly impossible to achieve returns that are high enough to compensate inflation. Accordingly, savings lose buying power over time if they are not invested properly to at least compensate inflation (also check out Why Start Investing?).
But besides that, investing in the stock market can still provide steady returns over the long-term. The average annual return of the stock market (S&P500) was about 10% per year in the last century. And that includes all crashes, e.g. the great depression, the dot-com bubble or the financial crisis. This shows that while there are always stock market crashes, the markets have always recovered and reached new highs. But of course, past returns are no guarantee for future returns. Considering the rally we have experienced since the financial crisis, I personally expect lower returns over the next decade in the range of 5-7% per year on average. But what is compound interest?
What is compound interest?
Compounding interest means to earn interest on interest that you have already earned. It is based on the principle that interest you earn from your investments are reinvested and therefore also provide interest over time. Obviously, this is not a get-rich-quick overnight scheme and requires patience and a long-term investment approach. But if done consistently, compound interest can grow your net worth at an accelerating rate over time. Below you will find some examples for that.
Even Albert Einstein considered compound interest to be the most powerful force in the universe (at least it is said that he did).
How compound interest can grow your net worth over time
In the following, I would like to show you three different examples of how compound interest can steadily grow your net worth. Let’s assume you are 30 years old and start investing in the stock market using ETF’s that track an index, such as the MSCI World or the S&P500. Accordingly, you are following a passive investment approach and do not consider stock picking or market timing. You would like to retire at the age of 60, so your plan is to save and invest consistently over a 30-year period. Moreover, you continue to invest regardless of any market events such as a crash. The average annual stock market return is assumed to be 5% for the next 30 years. This is a conservative assumption in my opinion.
- Person 1 is single and works in a minimum wage job. The initial investment is €1,000. Due to the low monthly income, person 1 can only invest €100 per month.
- Person 2 is married and has 2 children. Person 2 works in a well-paid full-time job, his/her wife/husband works only part-time. The initial investment is €5,000. As a family with 2 income streams, person 2 can afford to invest €500 per month.
- Person 3 is a business owner and thus earns a high income from his/her business. He/She is married and has 2 children, but his/her wife/husband does not need to work. The initial investment is €10,000€. Person 3 can afford to invest €1,000 per month.
Of course, these are just examples and everyone’s financial situation is different. Let’s take a look at the total savings of each person after a period of 30 years.
Person 1 – Minimum wage job
Based on the assumptions above, an initial investment of €1,000 and a monthly contribution of €100, person 1 will be able to build up total savings of around €88,040 until retirement. The total investment will be €37,000.
Person 2 – Family with two income streams
Based on the assumptions above, an initial investment of €5,000 and a monthly contribution of €500, person 2 will be able to build up total savings of around €440,202 until retirement. The total investment will be €185,000.
Person 3 – Business owner
Based on the assumptions above, an initial investment of €10,000 and a monthly contribution of €1,000, person 3 will be able to build up total savings of around €880,404 until retirement. The total investment will be €370,000.
It is all about consistency and patience
The key lesson from these examples is that growing your net worth and building wealth is independent from your income level. Of course, someone who earns more money can save and invest more money and thus faster grow wealth than someone who earns a minimum wage. But in the end, it comes down to consistency and patience.
The examples clearly show that the compounding effect is rather small in the beginning. In the first 5 years the effect is almost invisible. But from the 10th year on, the effect starts to accelerate and after 30 years, the portfolio will have more than tripled. So, to achieve such results, it is mandatory to consistently follow the strategy defined and patiently wait for the portfolio to grow.
Thereby, I need to mention that the assumptions above reflect a perfect but unlikely scenario. The calculations are based on the assumption of a linear growth of the stock market of 5% per year. In reality, however, the annual returns will vary significantly. In some years, growth could be higher, perhaps as much as 20 or 30%. But in other years, there will be corrections or even a crash in the markets, causing your portfolio to decline. But especially during such years a good strategy could be to even increase your monthly contribution, cost average down on your positions and benefit from the recovery of the markets.
Compound interest and inflation
Another important factor to mention is inflation. For example, if we take a look at person 1, with estimated total savings of €88,000 after 30 years, the buying power of these €88,000 will be significantly lower in 30 years than it is today. Based on an estimated inflation rate of 2% per year over the next 30 years, the buying power of €88,000 in 30 years will be roughly equal to the buying power of €48,500 today.
The easiest way to compensate inflation is to increase your monthly contributions year after year. Let’s assume person 1 considers to increase the monthly savings rate by 5% each year. So, in the first year monthly savings rate will be €100, in the second year €105 (+5%) and so on.
In this way, and under the same assumptions mentioned above, person 1 will have total savings of €159,192 after 30 years. The total investment in this case will be €80,726.
Of course, wages do not typically increase by 5% every year. But this example should be considered as a motivation to increase savings rates whenever possible. For example, when I personally benefit from a wage increase, I usually do not inflate my lifestyle accordingly, but contribute at least 20-30% of my wage increase to my monthly savings. However, there are many other possibilities to save and invest more money (also check out 9 Starting Points To Save And Invest More Money).
Compound interest and dividends
Dividends paid by the companies can additionally accelerate your portfolio performance. Did you know that ETF’s also pay dividends? This is often not recognized because many ETF’s automatically reinvest your dividends. However, there are also ETF’s available that pay out the dividends. Let’s assume that person 1 chooses to invest in ETF’s that pay out dividends to investors. The dividend yield is 2% and the dividends received are reinvested by person 1.
This will further grow the portfolio and person 1 will be left with total savings of €220,312 after 30 years. The total investment in this case will still be €80,726 (excl. reinvested dividends).
The interesting fact is, if the final portfolio value is approximately €220,000 and the dividend yield is 2% per year, person 1 will receive a total of €4,400 in dividend payments per year or about €365 per month. This is a great way to build up an additional income stream during retirement without having to sell any stocks.
I hope that this article helps you to understand the power of compound interest. I think most of you already know about it, but I wanted to remind the importance of it and a long-term investment approach. Knowing the power of compound interest is also the foundation of My Personal Long-Term Investment Strategy.
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