Compound Interest
Compound interest, the exponential builder of wealth
What is compound interest?
In short:
Compound interest is the interest (or rate of return) on both the initial investment and the interest the initial investment generates. Compound interest is a powerful tool because you get paid interest on a larger and larger amount every compounding period.
FORMULA:
The factors that make the biggest impact on the growth of money with compounding interest are the length of investment and interest rate (rate of return). This is why legendary investors such as Warren Buffett or Charlie Munger encourage investing early in life because the biggest gains are in the later timeframe of the investment.
In-depth:
There are four components to compounding interest. They are the initial investment, the interest rate, the length of investment, and the number of compounding times per year. Commonly, the two most powerful parts of compounding interest are the interest rate and the length of investment, however, compounding periods can have a significant impact on the growth of the investment.
Different forms of investment have different compounding periods. When investing in stocks the compounding period used is annual but when investing in a CD, savings, or money market accounts the compounding periods are often daily, monthly, or semi-annually. Savings and money markets are often daily while CDs vary. If you have a choice, it’s best to use the smallest compounding period possible. A smaller period applies the interest to a larger and larger growing investment faster than a longer compounding period, although as the periods get smaller the boost they give gets smaller.
Compounding period examples:
Daily compounding: Let’s say you are going to invest $5,000 in a money market account that is paying 3% interest with a compounding period of daily. After three years your account would be worth: $5470.85
Monthly compounding: Now let’s take the same example from above and only change the compounding period. We now have an investment of $5,000, an interest rate of 3%, and a compounding period of monthly. After three years your account would be worth: $5,470.26
Annual compounding: Even further demonstrating the concept of compounding periods let’s extend our example from above. Now have an investment of $5,000, an interest rate of 3%, and a compounding period of annual. After three years your account would be worth: $5,463.64
As you can see low savings rates in banks, while allowing you to grow your wealth, do not provide much of a meaningful return especially on small amounts of money. Changing the compounding period did help but only marginally in our cases. Since this is the case in today’s economic environment, many investors look to the stock market instead.
Compounding interest used in the stock market:
The real power of compounding interest has been felt by many through investing in the stock market. This is especially true for investors who are not looking to “beat” the market (S&P 500) but simply just match it. In this case an investor might expect to earn an average of 10-11% per year since this is the annual average of the market over many years. It should clearly be understood that this higher rate of return is because of an exchange of risk. The stock market is a riskier place to put your money than the bank. The bank will return your money at the end of the investment period where the stock market may not or may lose it all.
Stock market example
Let’s say you’re an aspiring young person who wants to put their money to work. You want a better return on your money and are okay with more risk. So, you invest $5,000 in the market, leave it there for three years, and are able to earn 10% per year. After three years your investment would be worth: $6,655
- From here the real power comes in, you leave your investment there for another 15 years. After another 15 years your investment is worth: $27,799.59
- What about until you retire? Say retirement is an additional 20 years away. Your investment would be worth: $226,296
Time Value of Money:
The core tenet of compounding interest is the time value of money. The time value of money is the idea that money has more value today than it does tomorrow.
Look at a logical example to help make more sense of this. If someone could choose between receiving $1,000 today and $1,000 in a year, the vast majority would pick to receive the money today, (this is economically rational). Now, if the scenario changes to receiving $1,000 today or $1,100 in a year, the number of people who choose today vs a year change. More people will choose a year from now rather than today so that they can receive the extra $100, how many changes depends on the other opportunities available at the time to use that $1,000.
The extra $100 or 10% represents the Time Value of Money. How much does it cost for a large number of people to forego having money today for money sometime in the future. This depends on the other opportunities available at the time.
How long to double my investment?
The quickest way to figure out how long it will take your investment to double is to use “the rule of 72”. This is a quick and relatively accurate way of calculating how fast your investment will double at a certain interest rate.
To use the rule of 72, simply divide 72 by your interest rate, ex. 72/ i, the result is the number of years it will take to double your investment. An example of this, say you believe you can obtain a rate of return (interest) of 10%, 72/10 = 7.2, it will take you 7.2 years to double your investment. What is a good interest rate for me to use? If you are invested in the stock market with a portfolio similar to the S&P 500 then you can expect to make an average return of 10-11% per year. This is the average return for the S&P 500 over many decades. That said, the stock market performs differently every year so one year might be low and another might be very high.
You can find compound interest calculators at https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator