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The Power of Compound Interest

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The Most Powerful Force of the Universe

One of the most cited quotes ever is the one attributed to Albert Einstein, that “compound interest is the most powerful force of the universe”.  Although there’s no evidence that Albert Einstein actually said this, the idea behind this sentence is that if you use compound interest in your favor the returns will be huge.

What is Compound Interest?

Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of the investment.

Example:

If you have $1000 and earn 5% in interest, you will end up with $1050. (1,05 x 1000)

Next year if you earn an additional 5% in interest you will now have $1102.50. (1,05 x 1050)

Virtually every investor, or successful business owner, relies on the magic of compounding interest to grow their savings. Thus becoming financially independent.

How to Use it to get Rich?

There are a number of factors in order for you to start using compound interest. The amount of money invested, the interest and of course time.

If you invest $10 000 and never touch again (not even to add more money), and leave it there for 50 years, your returns can vary from $114 674 to $10 836 574. As you can see from the table there are two key factors to maximize the use of this concept: Time and Interest.

Time

The more important concept is that the early you start, the further you will see the compound interest “force” working for you. Starting with $10 000, waiting 50 years, and even with a small interest of 5%, you will end up with over $114 000. You’ve just multiplied your investment by more than 10 times.

Interest

Having higher interest rate can really help you to maximize the use of this special force. That’s why it’s important to add stocks to a portfolio. You will have more volatility, but you will also have a higher expected rate of return.

 

Source: Vanguard.

Stocks/Bonds Mixed Portfolio

If you invested $10 000 in 1926, through a mixed portfolio of 70% stocks/30% bonds (ETF weren’t invented yet…but just for fun), you’ll end up with a yearly return of 9,1% – not taking into account taxes. This means that in 2016, 90 years later, you would have amassed a small fortune: over 25 million dollars. Without ever adding any money to the initial investment.

Compound Interest…a great force indeed!

Compound Interest: From $10k to $25 Million! #Investing

Is it Easy to Have Returns above 15%?

Well according to Jeffrey Ptak, it isn’t.

Of the 5,697 unique mutual funds that had at least one 10 yr net return in the 40-year span 4/1/78 – 3/31/18, 407 had at least one 10-yr period in which its CAGR >= 19% p.a. More than half of those occurred just before the tech/internet bubble burst in ’00. Since the 10-yr period ended 3/31/13, there have been no more than 5 funds w/19%+ CAGR in any rolling 10-yr period. It’s been very quiet in that regard. There are 7,075 rolling 10-yr periods in which a fund generates a 19%+ CAGR after fees, of 743,732 rolling 10-yr periods total across all funds. So, essentially, funds generated a 19%+ return in about 1% of all rolling 10-yr periods that happened within the 40-year span ended 3/31/18.

1% of them had a return of 19% or more. That’s what some would characterize as “outlier“.

What’s my point? That it is incredibly hard to generate high-interest rates on your investments for long periods. That’s why I prefer the returns of the market, plain and simple. I can control (minimize) costs, choose a world diversified ETF, and stay the course.

Easy to understand and to maintain throughout the years. Keep it simple.

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About GTRetire

GTRetire is the founder of GrowtoRetire, a blog about financial independence and early retirement. Click here to learn more about starting a blog! Also, this post may contain affiliate links, please read the disclaimer for more info.

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