A key principle of long-term investing is having the power of compound interest work in your favor over time. Quotes about the magic of compound interest abound among history’s greatest thinkers; for example, Albert Einstein referred to compound interest as the Eighth Wonder of the World. This article will review compound interest and how a long-term investment plan can turn seemingly small steps on a savings path into a bountiful result. Warren Buffet has referred to compound interest as rolling a snowball down a hill. As the ball progresses, it gathers snow faster and faster until it becomes a giant. For investors, Buffett says the best results come from having a long hill—either from starting young (within our control) or living a long time (totally unknowable).
At its core, the idea of compound interest is that when you make an investment, both your initial cash outlay as well as all future income from that investment are working in your favor. To keep the math easy, if you buy a long-term Certificate of Deposit (CD) with $1,000 that yields 10% annually (unrealistic in current market), in the first year that CD will earn $100. However, in future years, your annual return on the initial invested amount is actually more than 10%, as in year two you would earn 10% on your initial $1,000 as well as the first year’s interest of $100 for a total return in year two of $110. Over time, this interest earned on your interest can add up to significant savings/returns. This works the same way with other long-term investments as well. With a $100,000 portfolio invested in the stock market, earning 9% per year and keeping those returns invested would yield a portfolio more than double the size in less than a decade.
An interesting illustration of this power can be shown by comparing investment results from starting early to waiting to begin investing and playing catch-up with your portfolio. Imagine Investor A starts saving at age 25 and puts away $5,000 a year for seven years into a diversified stock portfolio earning 10% annually, on average. Due to the magic of compounding interest on these gains, by the time Investor A turns 63, they would have over $1 million saved after contributing just $35,000 in total when they were first getting started. Conversely, let’s say Investor B did not start investing early and waited until age 32 to start (the same age Investor A was done contributing to their portfolio). Even earning the exact same return on the portfolio, Investor B would have to contribute $5,000 per year for over three decades—adding $155,000 in total—just to have a similar-sized portfolio at age 63 as Investor A who started letting returns compound in their favor several years earlier. This seems crazy: waiting just seven years to get started on a lifetime of investing ends up requiring more than quadruple the contribution amount to have the same end results!
A key takeaway from this post should be that there is no amount too small to begin investing for your future. Even a small, regular contribution into an investment account—when factoring in compound interest—can become a large pot of savings at the end of your investment timeline. Saving only $25 a week into an investment portfolio yielding 9% annually turns into over $120,000 in 25 years. Obviously, as the contributions get bigger, so does the ending value ($100 a week becomes nearly half a million dollars). Importantly, the earnings received on your contributions during the 25 years trounce the total amount contributed by a factor of more than 2-to-1. The most important keys are to stay invested through all market cycles and to be consistent with your savings plan. If you can make paying yourself a regular part of your budget by adding to an investment or high-yield savings account, you can start the clock ticking on an investment lifetime of compounding gains.
For parents and grandparents that might want to help younger heirs jump start this process, there are multiple investment accounts available, even for minors that would have the funds remain in complete control of a custodian (the parent or grandparent) until the beneficiary’s age of majority—usually age 18 or 21 depending on the state. Up to $19,000 per year can be gifted annually without reporting the gift to the IRS or filing a gift tax return that would reduce your lifetime estate tax exemption amount. Especially for younger workers that are tight on cash flow and might be unable to save significant amounts, helping them get started investing in a Roth IRA (if child is working) or brokerage account (any age or employment status) can be a wonderful lifetime gift.
According to a Chinese proverb, the best time to plant a tree was 20 years ago. However, the second-best time to do so is now. This thinking applies to investing too, as it is never too late to get started and take advantage of the magic of compounding.
When you keep your contributions invested, both the initial contributions as well as all the returns on those contributions continue working for you in the market, helping lead you toward long-term financial success.
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