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