Compound Interest
One of our founders recently went on a Christmas cruise with his family around the Caribbeans (pre-covid, thank god). By all accounts, it was a pretty awesome seven days of amazing food, endless entertainment, and some pretty gorgeous views. One morning, while spacing out during breakfast, he suddenly had a pretty crazy idea:
Is it possible to live on the cruise forever, without working?
It seemed outlandish yet awesome, so he refilled his morning coffee, grabbed his pen and a napkin and did some quick math:
Assuming the cost of staying on the cruise for one week is $1,000 (the trip he was on was priced between $800 to $1,200 depending on the time of year).
He multiplies that by the 52 weeks in a year to get $52,000 per year.
Since everything else (food, drink, entertainment) is covered on the cruise, the total annual expense (liability) should stay around $52,000 assuming no additional spendings.
Remember, one key assumption is not having to work. Therefore he had to find out how much money he needs to invest in order to generate enough investment income (ROI) to meet that $52,000 expense. For this thought experiment, he used the most commonly available ETF, the SPY (more on these later) which historically has returned around 9% per year annualized.
Assuming 2% inflation, the real return of the SPY would be 7%.
To find the amount he needs to invest, he divides $52,000 by 7% and gets $742,857.
This means if he invests $742,857 into an investment that pays out 7% annually, he will receive an additional $52,000 every year. His annual expected investment income perfectly cancels out his annual expenses, which in theory will allow him to keep enjoying the ocean views indefinitely.
Once again, this example is purposely designed to be overly simplistic. We are not encouraging everyone to spend eternity on cruises, but merely demonstrating how your desired lifestyle influences your money decisions.
Is This Feasible…?
Maybe $742k sounds like an impossible target, but we would argue that most people have a decent shot at reaching this goal, and your chances only get better the earlier you start. Don’t believe us? Here’s how:
Assume that you are currently in your 20's and planning to retire in your 60's; this gives you roughly 40 years
Assume you can get 9% ROI (Return of Investment), annually
Index Funds / ETFs, and other financial investments have historically demonstrated the ability to yield 9% over a long period. More on that later
Assume you are starting out with nothing, zero dollars
In this situation, if you are able to save $6 per day (the cost of a latte!), and invested that money starting in your 20's, you will end up with $743,000 by the time you are ready to retire.
If that caught your attention, here is the real magic: over the course of those years, you actually only saved $87,600 ($6 x 365 x 40), the rest of that $743,000 was entirely the result of your 9% ROI and your patience. Isn’t that crazy? You put in $87,600 and take out $743,000!
This is where we will mention something you’ve probably heard before: compound interest.
The 8th Wonder of the World
Think back to your childhood memories of playing during the winter snow (if you're from California, then use your imagination). What happens when you start rolling a snowball? It gets bigger. The small snowball you made with your hand pickups more snow as you roll it around, and the whole thing grows bigger and bigger. Compound interest works in the same way, but with your money.
You start by investing a small amount of money each month, and if you invest it with a positive ROI, it starts generating more money. Pretty soon you are sitting on a neat pile of cash. For a more numeric explanation, let’s look at some numbers:
Imagine you start out with $1,000 and you invested it into a stock that returns 10% every year (ROI = 10%). After the first year, you have $1,100, you’ve made an extra $100, not bad. However, after year two, you end up with $1,210 instead of $1,200. Wait a second… you earned $100 in year one, but $110 in year two.
Pay attention cause this is important:
Because the money you earned in year one (the additional $100) is also experiencing that 10% ROI, it increased your year two earnings compared to year one. Here’s a table of what it looks like over ten years:
Year 1 profit: $100
Year 2 profit: $110
Year 5 profit: $146
Year 10 profit: $235
Notice how you are not only making a profit every year, but the amount of profit you receive increases annually (i.e. in year 1 you are $100 richer than today, but in year 10 you are $235 richer than year 9). This is why compound interest is so magical; each dollar you earn immediately goes towards helping you earn even more money. Your money not only grows, but its rate of growth accelerates with time.
That brings us to the next point about compound interest: the longer you stay with it, the better, tying into the "Time" aspect of our wealth formula. Actually, that’s a bit of an understatement. Each additional year is much more powerful than the last in its ability to grow wealth. Let’s say you invest $1,000 into the same 10% ROI as before:
Scenario one: you are able to stay invested for 10 years, you end up with $2593.74, take away your initial $1,000 and you’ve made $1,593.74 in total profits.
Scenario two: you stay with the investment until year 15. You now have $4,177.25, meaning you’ve made $3,177.25 in total profits.
Notice how it took 10 years to generate $1,593 in profits, but it only took an additional 5 years to double profits to $3,177.25. You made twice the money in half the time!
Notice how the as time goes on, the amount of profit generated begins to dwarf the initial investment of $1,000? The profit generated by the 10% ROI grows larger and larger with each additional year. This is the power of compound interest.
When to Start Investing
To further illustrate the impact time has on your future net worth, let’s summon three hypothetical individuals, Jack, Jill, and Joey (why their names all start with J is unknown to science):
Jack invests $200 per month starting at age 25
Jill invests the same $200 per month starting at age 35
Joey invests $200 per month starting at age 45
Assuming all three of them invested in the SPY ETF which continues to provide a 9% ROI as it has in the past 100 years, what will each person’s net worth look like by age 65?
Please start investing as early as possible (and don’t be like Joey).
Be Careful…
“Compound interest is the 8th wonder of the world. He who understands it earns it… he who doesn’t pays it.” - Albert Einstein
We have explored the explosive power of compound interest, but like smart boi Einstein warned, it can also work against you. Remember that the magic of compound interest comes from a positive ROI and time. So, what happens if you have a negative ROI?
Well, bad things. Take the earlier example and keep everything the same, except change the positive 10% ROI to negative 10%. How much of our original $1,000 would we have at the end of 10 years?
$348.68… Ouch…
Question: how can you get a negative ROI? Well here are two common examples:
A bad investment
A loan
Everyone loves to imagine being an early investor in Amazon.com, but what about Pets.com? These two e-commerce companies came out around the same time, and while Amazon.com initially sold books (they later expanded a bit), Pets.com sold pet supplies (shocking, I know).
The difference between the two companies is that while Amazon.com found massive success, Pets.com eventually shutdown. If you invested $1,000 in its stock at their IPO, you would have gotten back $17.27 (a 98% loss). That’s an ROI of -36.41% PER MONTH!
Although negative ROI from bad investments sounds terrifying, there’s actually something far worse than losing 98% of your money.
If you borrow money, the interest you pay on that debt is effectively a negative ROI. If badly managed, debt can often grow to many times the money you originally borrowed. Imagine having to pay back $10,000 for a $2,000 purchase. This might sound insane it happens all the time.
At the worst, a bad investment can reduce your money to zero. A bad loan, however, can not only take you to zero but also far into the negative. You do not want compound interest working against you.
Now, does that mean all loans are bad? Of course not. Most of us borrow money to buy houses or cars, but that doesn’t mean taking out a loan will destroy our finances. When used carefully, responsibly, and intelligently, loans can be an amazing booster for growing your wealth, the key is in choosing the right type of loan and using them well.
Up Next…
Join us as we dive into the world of debt, learn about the most common forms of debt, and explore how they can help or hinder your financial progress…
