Investing: A Primer for BEGINNERS. Part 3

The Miracle Of Compound Interest

Ask any investment advisor what's the most powerful force in the investment world, and odds are you'll hear "Compound Interest" as the answer.

What is it? 

If you don't already know, here's a simple explanation. At its fundamental level, comound interest is interest you earn on other interest.

To make it a bit clearer, let's say you invest $100 at 10% interest. The first year, you would of course earn $10 in interest, which is 10% of $100. The second year, you are earning interest not only on the original $100, but also on the extra $10 you earned the first year. 

That's what compound interest is.

With the highest yield savings accounts and CDs only earning about 5% as of this writing, it seems like earning only $5 on a $100 investment over an entire year is chicken feed. 

If that were all there was to it, it would be chicken feed. But that's not all there is. 

What To Expect Over Time

If you're into investing for the long term, you won't keep all your investments in savings accounts and CDs. (If you do, then in my opinion, you're not really serious about investing.)

The Dow-Jones Industrial Average, if you look at it since they began keeping records, has reliably averaged about a 10% increase per year, even including the fluctuations in the economy. 

The more aggressive investments - and these are not the same year after year - have done quite well, often returning 20% or 40% or even double that. We aren't going to worry about those aggressive investments yet, because along with their high returns come equally high risk. 

Instead, let's say you will be putting some of your investments into CDs and a bigger proportion into some moderately safe other investments. For the purpose of fairly easy calculations, let's just say our demonstration accounts will be earning an average of 10% per year. 

Depending on where you invest, you might earn less, or much more. But for now, we will use 10%.

The "Rules" To Maximize Your Investment

If you want to make the very best use of the power of compound interest, to take full advantage of the miracle available to you, you'll need to observe a few simple rules.

Here they are:

1. Start early. As early as you can.
2. Leave the investment alone, for a LONG time.
3. Contribute regularly, especially in the beginning.

If you will observe these simple rules, you will be absolutely AMAZED at what you can achieve.

The "Twin Brothers" Example.

To demonstrate what a powerful force compound interest is, let's look at the famous example of Bob and Tom, twin brothers who decided they wanted to invest for their retirement. 

In this example, they both contributed identical amounts per year ($2,500), and both earned an average of 10% return every year over the life of their investments. And finally, they both planned to retire and never have to work again at age 55. 

But here's the difference: Bob starts at age 20 and contributes for ten years, then never contributes another penny to his account. Tom, on the other hand, waits until age 25 to start, then contributes every year until he retires at age 65. 

In this example, either because they pay taxes out of another account, or because this account is in an IRA (an Individual Retirement Account -- we'll discuss IRAs more in future articles), they don't have to deplete their retirement account to pay taxes. 

So what's the bottom line?

Let's start with the obvious. The total amount that Bob contributed, age 20 to 65, was 10 years at $2,500, a total of $25,000. Tom, on the other hand contributed every year, age 25 through 65, a whopping $102,500! That's $77,500 more than his brother put into the account. 

And what do you think the totals were in each brother's account when they finally retired at age 65? You can probably hear this coming, and it's true. 

Bob, who invested only $25,00, had a total of $1,354,838.42 at age 65, while Tom, who invested more than four times as much as Bob, had a total of $1,341,592.48. 

In other words Tom invested over four times as much, and still wound up with less. 

That demonstrates the power of rule number one: Get Started Early.

Both brothers invested only a moderate amount, something just about anyone serious about investing could afford, and both of them wound up with over a million dollars to retire on. Don't you think you could enjoy retirement with more than a million dollars in your retirement account?

This demonstrates the power of rule number two: Leave The Investment Alone For A Long Time,  and rule number three, Contribute Regularly.

Here's a summary of what each investment looks like as the brothers approach age 65:

Age Bob's Account Tom's Account
55 $522,348.86 $500,344.42
60 $841,248.06 $822,598.71
65 $1,354,838.42 $1,341,592.48

You can also see their accounts more than double in the last 10 years, THIS is the miracle of compound interest.

You can see or download the (MS Excel) spreadsheet I used to get these figures by clicking here. Feel free to save that spreadsheet to your computer and play around with the investment amount, the interest rate, and the number of years you plan to invest, to see how this miracle might apply to you.

Finally, if you're over 20, or even over 30, don't despair. 

You're NEVER too old to begin taking advantage of the miracle of compound interest. So if you haven't started yet, make a resolution to get started THIS WEEK.

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That's enough for now. In the next part, we'll get into some of the basics about the STOCK MARKET! Don't be put off by that, it's really not as complex as it sounds.. 

If you'd like to ask me a question, please use the Snicko contact page. I read them all, and I'll try to answer the most pertinent ones in this series of articles. 

Take care, and God Bless,

David