Why Compound Interest Is The Secret to Growing Your Wealth

Learn the outsized benefit of saving now rather than later, the cost of settling for “safe” returns, and how long it will take to reach your financial goals.

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” —Unknown

“Understanding the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” —Charlie Munger

The Power of Exponential Growth

Compounding, or compound interest, is a simple but often underappreciated concept. At its core, it just means earning interest on both your original investment and cumulatively earned interest, not just your original investment. Intuitively, we don’t expect this to make much difference—earning an additional fraction of a fraction doesn’t seem like much, and in the beginning, it isn’t. The real benefit is compound interest creates exponential rather than linear growth. Our brains have trouble grasping exponential growth because we rarely encounter it in our day-to-day lives. As a simple example, imagine I gave you the following choice:

1. I can pay you $1 a day for the next 30 days.
2. Or I can pay you one cent on the first day, two cents on the second, four cents on the third day, doubling every day for 30 days.

If you go by your gut instinct, you’d probably guess the second option is better but predict they ought to be similar. However, the first option pays you $30, whereas the second pays you $10 million. That’s the unexpected power of exponential growth.

The same thing happens with our investments, albeit at a slower rate. For example, if we compare how much $1,000 will grow, earning 7% per year:

Notice that as the compound return accumulates, it accelerates. We go from earning $70 on our $1K the first year to $350 in year 25, $500 in year 30, and $1,000 by year 40.

Compounding is also why debt (specifically high-interest consumer debt) is so problematic and challenging to get out from under—it’s the power of compound interest working against you.

The Cost of Waiting

The secret to maximizing compound interest is time—the longer, the better. To drive that point home, let’s compare a few simple retirement strategies:

1. Contribute $10,000 a year from age 20–29, then $0 a year from age 30–64 (total contribution = $100,000)
2. Contribute $0 a year from age 20–29, then $10,000 a year from age 30–64 (total contribution = $350,000)
3. Contribute $0 a year from age 20–39, then $20,000 a year from age 40–64 (total contribution = $500,000)
4. Contribute $0 a year from age 20–44, then $30,000 a year from age 45–64 (total contribution = $600,000)

Assume that, in all cases, we’re earning a 7% annualized rate of return, which is a fair target for our investments (even though many people settle for less).

Surprisingly, contributing only during your 20s outperforms the other strategies despite investing substantially less money. The longer you wait to begin, the more you’re squandering the power of compounding—stop planning and start acting. The most reliable way to become wealthy is not by earning a very high rate of return (which is probably very risky) but by finding a reasonable rate of return and compounding it over a long time.

The magic of compounding is why I’m a big advocate of teaching kids the basics of investing—getting them started early is the most significant gift we can give them for their retirements.

But don’t despair if you haven’t started saving by your 40s or 50s. Yes, you’ve missed a giant opportunity, but remember that your money doesn’t stop compounding the day you retire. For example, money contributed in your 50s can continue to compound until you withdraw it during your 80s or 90s.

The Rule of 72

The Rule of 72 gives us a quick way to estimate the time it takes to double the value of an investment. Simply divide 72 by your rate of return. For example:

• 3% = 24 years
• 5% = 14 years
• 7% = 10 years
• 9% = 8 years
• 11% = 6.5 years

If you want to account for inflation (as you should), subtract the average annual inflation rate from your rate of return before dividing it into 72. The result will tell you how long it takes to double your purchasing power rather than just double the value of your investment. For example, if you estimate a 7% return and 3% inflation per year, doubling your purchasing power will take 18 years.

The Cost of Mediocre Returns

Using these different rates of return, let’s compare the results of investing over 30 years, starting with an initial account size of $100,000.

I don’t know about you, but I find those numbers astonishing—that each 2% increase in your rate of return leads to a near doubling of your money over 30 years.

As a sober reminder, the unnecessary fees you pay for a typical active mutual fund over a lower-fee alternative like an ETF (which holds the same underlying assets) is often 2%+. These fees mean your bank’s standard advice could be reducing the growth of your investments by half over the long term. When considering risk, we usually only focus on how to avoid it. For example, how to steer clear of risky investments or reduce volatility. But what about the risk of mediocre returns, which leads to substantially less money for retirement? That risk is largely ignored, and we’re often encouraged to accept lower rates of return (or higher fees) for the illusion of safety without fully understanding the magnitude of the consequences.

Key Points

• Start investing as early as possible, ideally in your 20s—even smaller amounts will grow significantly, given enough time to compound.
• It’s never too late to start—even if you’re in your 40s or 50s, better late than never.
• Mediocre rates of return are probably the least talked about risk to your retirement portfolio—it’s as crucial as not contributing enough or early enough.
• Earning 2% more per year = twice as much money over 30–35 years.

Points to Ponder

• Do you know your investment rate of return over the past 10–20 years?
• Are you underperforming the market? If so, why?
• Do you know what stock markets have returned recently? I bet they’re higher than you think.
• Are you safely earning all that you could and should be?
• Is your financial advisor helping you make wise financial decisions or merely “safe” ones?
• If you’re young, could you be saving more?
• Will you regret not being more proactive and attentive to your retirement savings later in life?

Related Concepts

• Why Inflation Isn’t What You’ve Been Told and Why That Matters
• Why Passively Managed, Low-Fee Index Funds Are Ideal Assets
• Why Aggressive Portfolios Are Usually Safer Than Conservative

If you have comments, questions, or constructive feedback, you can contact us by email at questions@essentialsofinvesting.com.