For the next post in our Financial Planning 101 series, I have chosen to tackle compound interest. This is one of the most important things to understand as an investor. It’s important to know what it is. It’s more important to know the power it has on your portfolio’s growth. Quite frankly, compound interest can be life changing for an investor. Don’t believe me? Ask Albert Einstein, I heard he was a pretty smart guy.
What is Compound Interest?
According to Investopedia, compound interest is “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.” With simple interest, your interest accumulated is only on the principal, or the amount you invest. With compound interest, you not only accumulate interest on your principal but ALSO on the interest that you accrue. If you invest consistently over a long time horizon, the results can be robust.
The POWER of Compound Interest
You now know what compound interest is but why should you care? Why would Albert Einstein be so complimentary of it? Because it has the power to change your life. As an investor, it is extremely important to start investing as young as possible. Even if it is just $50 a month, starting young can have an enormous impact on your investments. I often meet with people that mention that they, “waited until we paid for our children’s education” or until “our kids were out of the house” to start investing. Life happens, I get it. It’s not easy to put money aside but it is necessary. Don’t wait until you feel comfortable enough to do it, life might throw some curveballs your way and you may end up kicking the can down the road too many times. Many folks have found that treating investing as if it were a monthly bill helps. If you treat it as if it were a fixed monthly expense, you won’t be as tempted to put it off and use that money for other purposes. Keeping an investing early and often approach can pay huge dividends for you in the long run. How can investing early and often impact your portfolio? Let’s take a look.
As you can see, if you were to invest $200/month with an average annual rate of return of 7%, waiting 20 years to start investing could mean a difference of over $420,000! The longer you wait, the harder it is to accumulate wealth. Also, as you get older and closer to retirement age, you may not want to invest aggressively because you have less time for your portfolio to recover from poor performance. This means that you gave up the opportunity to invest aggressively when you were younger. It is hard to quickly accumulate wealth when you don’t have as much time on your side. There are many variables that are out of your control. If you wait to save for retirement until you are within 10-15 years of retiring, what would you do if markets are flat the majority of those years? Will you have the cash flow at that point to invest enough to live on for 15, 20, or even 30 years?
Compound interest really can be the best friend to a disciplined investor. I cannot stress enough how important it is to start young and invest often. You really can’t afford to wait.
If you want to learn how to make compound interest work for you, click here.
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