You’ve probably heard about the power of compound interest before. Whether it is the well-known question as to which is better – a penny that doubles in value each day for a month vs. one million dollars (it’s the penny), or Albert Einstein supposedly stating that “the power of compound interest the most powerful force in the universe.” Throughout history, compound interest has been credited as a key driver of wealth creation.
Personally, I’ve heard this for my whole adult life, and while I believed them in the abstract, this concept recently became real for me when I saw this chart from one of our retirement accounts:
This shows that our initial investments in this account have been greatly surpassed by growth fueled by compound interest. Honestly, I sort of never believed I’d see this day. Hearing about the power of compound interest in the abstract is fun, but I guess I sort of thought time would never catch up with me. What’s even crazier is if this happened in roughly 10 years, how will these numbers look in 30 years!
Granted, the stock market has been on a crazy run for the last decade, so these returns are spectacular. But still, historically investors can expect around 8% returns annually, which means even under normal circumstances money roughly doubles every 9 years. If you’re investing in yourself by running your own business, and re-investing the gains, the rate of growth can be even more rapid. The bottom line is that compound interest is powerful, and anyone who aims to be wealthy should leverage it as a cornerstone of their approach. Discussed below are five ways to accomplish this goal.
#1: Start as Early as Possible: Compound interest takes time – like decades – to have truly extraordinary impacts. Have you ever noticed that ancient Vampires are always wealthy in the movies? That is because even a novice investor can get rich given enough time and even a modest amount of resources.
Let’s look at the financial impact of delaying investing. Each age above represents a potential key milestone in life, whether being someone who entered the workforce right after high school (age 18), went to college and just started working (age 22), or waited for a few years until they were 25, or 30. These numbers below assume everyone invests $100/month until the age 65.
- Age 18: $563,131
- Age 22: $378,293
- Age 25: $297,097
- Age 30: $214,257
These numbers clearly show that starting early has exponentially large impacts, but the numbers below are even more dramatic. Here a 25-year-old saves for 10 years followed by nothing else, compared to a 35-year-old who saves the same amount for 30 long years! Amazingly the 25-year-old has more in the end, despite investing considerably less. (Credit to the Federal Reserve Bank of Saint Louis – who has an excellent article on Compound Interest).
The point is simple – to harness the power of compound interest you must invest as early as possible.
#2: Invest Until it Hurts, While You’re Young
The optimal time to hustle and invest is while you’re young. Many people do the opposite, by partying hard during their 20s, only to wake up in their 30s with a car payment, large mortgage, credit card debt, and feeling that building wealth and reaching retirement is out-of-reach. Flip this script by working hard throughout your 20s by saving, investing, and perhaps building a business. This way when you enter your 30s, you could very well be set up for success for the rest of your life, regardless of what you do thereafter due to the power of compound interest.
Some will likely be quick to point out that health, economic, and other barriers may get in the way of this approach. And of course this is true to an extent, but it is better to aim high and attempt to overcome obstacles, rather than to give up before you even get started.
#3: Be Consistent
To have compound interest work on your behalf it is critical that you stick to your investing philosophy and avoid acting irrationally or rashly. I know at least one person who withdrew all their money from their investment accounts when the stock market cratered after COVID hit in 2020. The market fell 30% in one month, and many believed it would continue to fall for months to come. But nearly as quickly as this crash happened, the markets recovered, and then continued to climb to new record highs again, and again. This is not to say that you can’t ever change your investment philosophy – you really should be doing this as you learn and reach new milestones that change your needs and risk tolerance. But these actions should be thoughtfully considered and not done recklessly driven by feels of the moment.
#4 Make it Automatic
The human mind is still primordial in many ways. Many experts assumes that people make optimal, rational choices most of the time. Unfortunately for us, knowing the right choice and actually doing it is easier said than done. For example, most people know that the key to being in great physical shape is eating better and exercising. Yet a significant number of Americans are overweight. It’s not due to a lack of knowledge. It’s because making the correct choice, over and over again, is very difficult. The human mind only so much willpower and capacity to make difficult decisions.
To avoid this challenge, one of the best ways to maximize your likelihood of success is to automate your difficult decisions! This can take many forms, but a few great ways to automate your finances include:
- Enroll in direct deposit program if offered by employer
- Schedule recurring monthly transfers to a 401k, brokerage, or separate account for more entrepreneurial endeavors
- Sign up for annual or quarterly rebalancing for investment portfolio
- Set up automatic increases to retirement accounts, where offered by employers
- Establish online bill pay to avoid thinking about regular recurring bills
More information about how the importance of automating your finances can be found in the book, the Automatic Millionaire.
#5: Remember Inflation Has Opposite Impact of Compound Interest
Inflation is like a thief in the night, robbing you of your financial value without your knowledge. Even if inflation is limited to the Fed’s target of two percent each year, due to compounding this will slowly reduce the purchasing power of your assets overtime. Inflation is like the inverse of compound interest, in that it too builds on itself each year. An inflation rate of two percent is easy to swallow for a single year but how 100 percent over the last 30 years? With government debt at record highs, and potentially more massive spending on the way, anyone not paying attention to inflation is just not paying attention.
There are many investment strategies that can help hedge against inflation, but that requires an extensive discussion beyond the scope of this article (or my expertise). But overall, by investing you ensure that your money is growing overtime, which will help counteract the insidious nature of inflation.