Compound Interest: A Key Investment Principle

The best time to start investing is ALWAYS right now. When you have money to invest, put it to work, don't try to wait for the perfect moment or the perfect stock because they may never come. It's easy to be optimistic and start investing during bull markets but remember that you can snatch up some great bargains if you start investing in a bear market because everything is on sale.

If you are a beginner and have no clue what to buy, start with something simple like Vanguard's S&P 500 Index Fund (VFINX) or iShares S&P 500 ETF (IVV). Index Funds and ETFs are simple, inexpensive, offer great diversity and will guarantee the market returns, there's no better way to get started.

Regardless of market conditions or your investing experience, I say get in the game RIGHT NOW. Why? The sooner you start the better chance you give yourself to reach your wealth and retirement goals. You want your investing time horizon to be as long as possible. Not only does investing over long periods of time help you withstand the inevitable ups and downs of the market, but also gives compound interest more time to work its magic.

Your money can't work for you if it's on the sidelines. Many beginners have a very low risk tolerance and want to avoid losing any money. Paradoxically, they also often expect superior returns. It doesn't work that way, there is no such thing as risk-free investing if you want the average market return of 10.5% or better. As long as you select a good long term strategy and adhere to the basic principles of investing, history has NEVER failed, you WILL make money.

The stock market is the greatest wealth-building tool the world has ever seen. Why? Compound Interest. While this might sound very “mathy” and boring, I want you to get excited when I talk about compound interest because it's the closest thing to magic you're ever going to see. Albert Einstein once declared that compound interest is “the most powerful force in the universe” and I agree because it certainly has made a lot of people rich. It's a simple concept and is best demonstrated through examples.

Let's say you have $10,000 in a savings account that pays 3% annually and you don't withdraw money for three years.

  1. After one year you will have $10,300 (10,000 X 103%)
  2. After two years you will have $10,609 (10,300 X 103%)
  3. After three years you will have $10,927 (10,609 X 103%)

See? Compound interest is a simple concept. Now you're probably thinking “whoopee I made $927 in three years, so what?” So let's apply this to a real life example.

Let's say that you make about $50,000 per year and you've decided to contribute $417 per month (10%) to your 401k. Your company also has a company match program up to $5,000, which means they will match your contribution dollar-for-dollar up to $5,000. That means your total annual contribution will be $10,000. You put all of your money into a low cost S&P 500 Index Fund because you know that, since 1975, the average return for the S&P 500 has been 10.5% (and this average is just the capital gains, it doesn't even include dividends!).

So our scenario is that you will invest $10,000 per year and you will receive the S&P 500 annual return of 10.5% (compound interest at 10.5% + $10,000 savings per year).

  • After 5 years you will have $61,662
  • After 10 years you will have $163,246
  • After 15 years you will have $330,600
  • After 20 years you will have $606,308
  • After 25 years you will have $1,060,522
  • After 30 years (the length of the typical career) you will have $1,808,815

What if you reinvest all those dividends and manage to get your average annual return up to 12%? After 30 years, you will have $2,413,327.

Not too shabby. So if you haven't started investing, what are you waiting for?

What about the effect of dividend and capital gains taxes? The above example is a 401k, you are investing Tax Free so you won't pay any taxes until you start withdrawing at retirement.

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