Investing early is powerful. Unless you are a professional day trader, it will be really hard to match the gains of someone that has been investing in stocks that has been outperforming the market for multiple years. This is due to compound interest. Compound interest is a powerful mathematical concept that allows exponential growth.
Compound interest means that you earn interest over a principal which we can also call as initial investment. For the first term, you earn interest over your initial investment. For the second term, you earn interest over your initial investment plus your first term interest. This means that over time you will be earning interest over interest, and this is why compound interest is exponential.
In the world of the stock market, the percentage gain of the stock for the day is the interest for the day. If you take the percentage gain for the year, that is the interest for the year.
The Power of Compounding
To further understand Compound interest, let us look at a simple example.
We have two individuals named Person A and Person B. They both plan to retire in 10 years, Person A believes that saving up money and keeping it aside is the best solution for his retirement. Person B believes that investing his savings into an index fund that has an average annual return of 14% is the best solution for his retirement.
Both individuals start with an initial amount of $10K and every year they add $1K into them. Here are the details of both cases (Person A saves the money, Person B invest the money):
Both tables at the bottom left represent the total value of their investment over the years. We notice at the end of year 10, Person A has a total of $20,000 and Person B has a total of $56,409.51. Person B has almost triple the value of Person A, this is due to compound interest.
The compound interest is the contributing factor to the difference between Person A and Person B’s total value over the same period of time.
Here is a graph representing both Person A and Person B total value over time.
We notice that the curve of Person B is following an exponential curve. The difference between both lines keeps increasing over time due to the interest getting greater and greater over the years.
The example we have seen was calculating a person investing $10K initially and then adding $1K per year for an annual return of 14%. All these 3 variables can be modified to your liking. The only variable that is hard to control is the annual return depending on the asset you invested in. If you choose to invest into stock, stock can vary from +100% gain in a year to -30% gain in another year. The safest method is to choose and make a solid portfolio or to choose an index fund or actively managed fund. It is important to choose assets that have great returns over years. Just investing in the top 5 companies of the S&P 500 will provide you with more than 14% a year which was the interest rate that was used in the example.
In the example, we chose to add $1K every year to the investment, this was a very light approach. Someone that wishes to invest aggressively can very well put aside $1K every month and invest it. This will drastically change the outcome of your total investment value.
The best way to have a good plan for your future is to simply make a reachable goal using an online compound interest calculator. You can then test different numbers and see what works best for you and what approach you wish to take. The variables you have to play with are interest rate, your initial investment, any additional investment made on a monthly or yearly basis and the number of years you are willing to let your investment compound.