- Saving and Investing can be hard but it doesn’t have to be. Using the compounding effect makes it easy and powerful.
- The compounding effect of investment returns means that investing over a long period of time can generate significant profits. That’s why it’s important to get started early even if it’s just a small amount.
- This article demonstrates just how powerful this tool can be in practice and the reasons why you should get started using it as early as possible.
Investing is intimidating. Big scary terms and acronyms like stocks, bonds, IRA’s and 401k’s can be overwhelming so let’s look at a very simple but powerful investing tool that everyone should take advantage of. It’s called compound interest.
Simply stated, compound interest allows the saver to earn interest on interest as opposed to just earning interest on principal.
How does it work? Why does it matter? Consider this…
Below, I have created a simple graph which outlines four portfolios. In each case, $5,000 per year is invested up to age 65 and the annual return is 7% (approximately 1% less than the historic average annual return of the US Stock market — very achievable!). The only difference between the portfolios is the age at which the investors started to save.
- Green line — Starts at age 25
- Orange line -Starts at age 30
- Blue Line — Starts at age 35
- Red Line — Starts at age 40
The portfolio of the person who starts at age 25 accumulates more than $1 Million dollars and more than double the amount of the person who started just 10-years later at age 35.
Shocking right? How about this one…
Assume your friend Joe invests that same $5,000 per year starting at age 25 but stops investing after 15 years at age 40 but continues to lets his investment accumulate compound interest through age 65. Our other friend James starts at age 35 (10 years later) and invests the same $5,000 per year until he’s 65 (30 years of investing — double that of Joe’s).
Joe, who only invested $75,000 but started earlier still has more money than James by the time they reached age 65 even though James invested DOUBLE what Joe did. That’s the power of starting early.
Beginning at age 25 might not be realistic for everyone. The job market is extremely competitive, many millennials are burdened with student debt, planning for marriage or starting a family. However, the figures outlined above show how much of a difference even 5-years can make and technology has made it very easy for anyone to get started with compound interest (which you can read more about here).
If you’re left wondering how you can save an additional $5,000 per year in order to get started on reaching this goal, adjusting your coffee consumption might be one of the easiest ways…