The Power of Compound Interest

"The most powerful force in the universe is compound interest." -Albert Einstein

The basic concept of compound interest is so remarkable that it is arguably more important than understanding any advanced theories of investing. This is because the sooner you take advantage of compound interest, the more wealth you will be able to ultimately attain. Of course if you think money is the root of all evil, you need not look any further.

So what exactly is compound interest? Say you have $100. You put that money in a bank that promises you a 5% annual return. After one year you will have $105 ($100 plus the $5 interest). The next year you will once again receive 5% return. However, now that your account has grown by $5, you will be getting 5% return on $105. At the end of the second year you will have $110.25 ($105 plus $5.25 interest). You have gained an additional $0.25 in added interest from the previous year. Not impressed yet? As Wyclef Jean said, "Don't worry." Let's elaborate on this concept further.

I will use a mock retirement plan in my example. Let's say that a 35-year-old is just starting to contribute to his retirement plan and would like to retire at the age of 67. At 35 he puts $5,000 as his initial retirement contribution, and each year until retirement he will add an additional $5,000. Let's further say that he invested everything in the S&P 500 index, which has returned about 11.36% annually since 1985. To summarize, the retirement time window is 32 years (67-35), $5,000 in contributions each year, and an 11.36% annual return. Total lifetime contributions ($5,000 x 32) = $160,000. At 67 he will have $1,640,800! That comes out to 1,025% return on investment (ROI), not too shabby.

And, best of all, we're just getting started. Let's keep everything the same from the previous example, except let's assume that instead of being 35 years old, he is 25. Now, at 67, he will have $4,907,000 (3,067% ROI)! What if, instead of contributing $5,000 a year, he decides to contribute $10,000 year? With a starting age of 25, at 67, he will have $9,800,000!

Let's play around with other variables. Instead of the index fund, let's assume he invested in American Growth Fund. Over its lifetime it has returned an impressive 15.5% return, but let's use a more conservative figure of 12.87% return which the fund has garnered over the past 10 years. This is 1.5% higher return than the S&P index return of 11.36% we used in the previous example. To recap, a 25-year-old with a retirement age of 67, and $5,000 annual contributions with an 11.36% annual return had $4,907,000. With the new 12.87% annual return, however, that same person would have $7,847,700 (4,905% ROI)! An additional 1.5% annual return, yielded a 60% higher ROI.

The earlier you start your contributions, the greater the benefit of compound interest will be on your portfolio. To illustrate this point let us take a look at one more example. The initial condition we used was a 25-year-old, with $5,000 in yearly contributions, and an 11.36% return. Assume now that we are dealing with a 45-year-old with the same retirement horizon of 67. The time to retirement is now cut to 22 years. Let's also say that the 45-year-old will contribute twice as much as the 25-year-old, or $10,000 annually. The same 11.36% interest will apply. Recall that at 67, the 25-year-old had $4,907,000. The 45-year-old at 67, however, will have $1,054,000. Not only did the 45-year-old contribute twice as much as the 25-year-old, he still ended up with 1/4 the amount of money, and a disappointingly low ROI of 330%.

The main idea is to start contributing to your retirement as early as you can, and as much as you can.