We have all, at one point, seen the boring investment schemes that claim to make single digit percentage gains per year. It may have been a small online bank that offers 2.5% per year on a savings account. Or maybe a US treasury bond that gives you 2-3% per year. Or even some dividend stocks that give you 5% or more. Although it’s not as sexy as a high flying Electric Vehicle stock, over time compounding interest can have a huge impact on your wealth. Even world renowned scientist Albert Einstein would agree. A famous quote he said was,
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
In this article, I will explain how compound interest can help grow your wealth, and some of the methods you can take advantage of to grow your wealth.
One might think, the people who can afford fancy cars and big mansions must have either inherited wealth. Or that they are successful entrepreneurs. Or maybe that they got lucky in the stock market.
Although, those are all valid arguments, for the majority of people we haven’t been given these opportunities. However, there are ways to build your wealth over time. Whether it is from passive investing, investing in real estate, or investing in your own business, they can all provide a similar level of wealth over a long period of time.
Since the S&P 500’s inception in 1926, it has returned an average of 10.49% per year. Adjusting for inflation, it has still returned 7% annually. For these reasons, the S&P 500 is the leading market benchmark for US stocks. 10.49% per year does not sound like much.
However, by using the Rule of 70, a rough estimate to calculate time needed for an investment to double, it would only take 7 years. Furthermore, by using a compound interest calculator, it would only take another 4 years to triple and another 3 years to quadruple. After 17 years, an investment of $100 in the S&P 500 would be worth just over $500. Although S&P 500 does not consistently return 10% per year, investors can expect these returns over a long time horizon of a decade or more.
What is neat about the compound interest calculator is that it can be used for any investment vehicle. It can be an investment property, private equity, US treasuries, indexes like the Nasdaq or the Dow Jones.
Benefits of compounding interests
A mental barrier for most investors is the fear of buying when the market is too high, and selling when the market is too low. Some years will be down for the S&P 500, other years will be up significantly, but the last 100 years have shown us that the S&P 500 can return 10% on average.
What is most important about this metric is that investors must keep their money invested in the market. This is because the greatest aspect of compound interest that no one has control over is time. If you were to sell your stocks to cover unexpected expenses, this could hurt the compounding aspect of your investment.
Even if you were to sell a portion of your investment but re-invest the same amount a year later, a whole year of compounding will be gone forever. Therefore, it is important to stay in the market and have discipline with your investments, rather than trying to time the market.
Taking it a step further
By investing consistently, investors can take compound interest one step further. Also known as Dollar Cost Averaging, investors that consistently invest will win over a long period of time whether the market goes up or down within a short period of time. This is because historically, the S&P 500 and most other indexes spend most of their time going up rather than going sideways or going down.
Following a similar example, an investor that invests $100 in the S&P 500 today and consistently invested $50 every month for 5 years, would have accumulated $3100 in principle but would have an investment worth over $3800.