Investing Series – Compound Interest Magic

Compound Interest
Rule of 72

Over the last few weeks we’ve introduced readers to the basic steps to investing in Canada. We looked at setting financial goals, creating a financial plan, the importance of saving, what asset classes are, what investment accounts/plans we have in Canada, and finally, what investing in stocks is all about. Now you get to see why all of this stuff is worth learning. Simply put, it can be your semi-guaranteed plan to meeting goals that you couldn’t otherwise meet. Using myself as an example, I am extremely motivated by the idea of an early retirement. I just think about getting out of the “rat race” and it makes me smile!

Make Money Without Working For It!

For those of you that are not at all familiar with Compound Interest, it is the basic idea that you will earn money on the money that you invest (the original amount is called the “principle”). The earlier you start, the longer it has to build on itself. Money can compound multiple times a year, but for our calculations we will use only conservative figures so that our results are not skewed; therefore, we will only calculate compounding yearly, and not monthly. If you pick investments that give you a reasonable rate of return, and use the savings vehicles we have here in Canada, you can grow your money tax free. To use a simple example, if you invest $1.00 today at a rate of 10%, in one year you will have $1.10. If you leave the money in and don’t let the government get any:), the next year you will have $1.21 and not $1.20. If you were to only earn a straight 10% on the money originally invested (often called the principle) that is called straight interest or simple interest. The extra penny you earned is a result of interest on interest. In other words the money you already made, makes you more money without you lifting a finger! Maybe I’m the only one that thinks this is a revolutionary idea, but I don’t think so. Here is a pair of quotes that I feel sum up the power of compound interest.

“I think of money like little soldiers that I send out everyday and their only goal is to bring me back more soldiers.” – Kevin O’Leary (Dragon’s Den)

“The most powerful force in the universe is compound interest.”

-Einstein (yes, THAT Einstein)

Grow Your Money Army!

I find it noteworthy that the most esteemed physicist (maybe even scientist) of all time said that compound interest was that powerful. I mean, we’re talking about the guy that made the nuclear bomb and quantum physics happen! I don’t think O’Leary is nearly as smart as Einstein, but he is a millionaire and undoubtedly knows how to make money. His simile gives a nice image of what compound interest is all about. Each day your army will grow and can bring back more prisoners, and that my friends, is how people like O’Leary and Warren Buffett get very big “armies” of money indeed.

Stats Don’t Lie (well sometimes they do, but not here!)

Let’s take a look at a few real life examples so you can see just how important the time frame is when we talk about compound interest. Most analysts out there today claim that the stock market will not continue to return the 10.7% it has returned in the past (on average). I happen to disagree with them, but the most pessimistic “experts” will usually still use a figure of 8% to predict future figures. I’ll split the difference and use 9% for all of my calculations. I will also assume for the moment that we were able to invest all of our money in registered accounts (which should easily be possible as we are not investing huge amounts of money every year) and that we never take money out, we just let it grow on itself:

Example 1: You invest 6,000 per year (500 per month) from the ages of 18-45. During those 27 years, you would have put a total of $162,000 away. While this is a nice sum of money, it isn’t exactly setting up for a comfortable early retirement; however we have not yet factored in compound interest. Without doing anything except smartly investing your money you would have about $672,000 waiting for you at age 45!

Example 2: In order to show just how important it is to start investing early we will look at a comparison example about twins named Jim and John (why do parents always name twins the most confounding things anyway?). Let’s say that John invests $500 per month from the age of 18-55. He makes more as he gets older, but he has a family and then travels a little and is only able to consistently put away that same $500 every month. His brother Jim on the other hand buys a new car out of school, enjoys spending his money, and lives pretty tight until the age of 30. At 30 he gets a promotion and starts earning a lot more. He takes John’s advice and starts saving and investing in the same way John does (earning 9% per year in a registered account). He is able to put away a lot more than his brother, in fact he is able to save triple what his brother does at $1500 per month ($18,000) per year. Jim figures that although he started a little behind his twin brother he most have saved a lot more than him after all those years of putting triple the money into his accounts. Is Jim right?

John = $500 per month, from 18-55 (37 years) = $1 689,000 (yes that’s seven digits), and invested only 222,000 of his original hard earned dollars.

Jim = $1500 per month from 30-55 (25 years) = $1 662,000

Wait a minute, WHAT? That’s why my boy Einstein had it right. John’s money army had a lot longer to grow itself and go out and get more soldiers. Take one more peak at those figures and tell me you aren’t thinking about living the good life at 55. It’s not like 500 per month is impossible right?

Example 3: If you are the type of person that just can’t sleep at night if your money is in stocks because you have just heard too many bad stories (I really do feel bad for you) the good news is that you can still make out great if you just steadily invest in safe, old fashioned bonds. If you invest $500 in bonds from ages 18-55 in registered accounts you will have about $571,000 available upon retirement. Not unbelievable, but still a nice little pot of gold.

I have to admit that I have presented these numbers a little out of context in order to show the power of compound interest. The fact is that in the above examples a million dollars would not be worth the same amount when you are 55 as it is right now. The reason for this is called inflation and we’ll look at it in depth another time. The point is that you won’t be living quite as comfortable as this might appear, but I would still bet 1.6 million would be enough for most of us! I also didn’t take into consideration that wages would probably also rise at an inflationary rate, but that is a much more complicated argument.

Try Capitalism On – I Find It’s One Size Fits All!

The bottom line here is that capitalism works if you’re a capitalist! This means that if you let your money work for you and put it where it will do the most good you will certainly come out further ahead than someone who constantly has to have latest trinket or the fanciest car. Start young, set goals, get into good habits, get educated, and then just sit back and watch your money grow!

Thanks for sticking with us through the investing series. Starting next week we’ll get you back to your scheduled programming and go back to talking about some nitty-gritty student-specific money issues.

About Teacher Man

TM is a self-professed nerd about all things related to personal finance. He can be found writing for My University Money, Young and Thrifty, and Canadian Personal Finance Blog. TM blogs in order to continue his quest for lifelong learning and hopefully to help others along the way.

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