January 2022
It is thought Albert Einstein said one of the most popular quotations about compound interest, “Compound interest is the eighth wonder of the world, he who understands it, earns it… He who does not, pays it.” Compound interest is the interest you earn on your original investment plus the interest you have accumulated previously. Most investors understand the basic concept of compound interest, but few truly understand how much compound interest can snowball into massive sums of money. To get a full picture of compound interest, we will look at investors in different scenarios.
First, we will look at an investor at the beginning of their investing journey. A common long-term goal for investors is hitting the $1 million mark for their portfolio. The following chart shows you different ages an investor began investing at while giving our investor an average yearly return of 8%. Based on the age of the investor, this is the amount of money they would have to put away every month to reach $1 million at the age of 60. The chart shows an investor who starts at 20 can invest less than one-third the monthly amount compared to an investor who starts at 35. Compounded at 8% a 20-year-old would only have to contribute ~$140,000 total over 40 years to grow their portfolio to $1 million, while a 35-year-old would have to contribute around $315,000.
Our next comparison is two investors which have both accumulated $1 million at the age of 60. One investor wants to play his portfolio conservatively while the other investor is comfortable taking a little more risk. The conservative investor compounds their wealth at 4%/year, while the more aggressive investor compounds their wealth at 8%/year.
As you see, the real power of compound interest comes later in life when you have accumulated a large amount of money. By allowing your investments to continue to grow, your portfolio will continue to grow exponentially. An important thing to remember is that later in life is when most investors start to withdraw from their investments to cover their day-to-day expenses. 4% can be a common withdrawal rate. With a 4% withdrawal rate, our first investor will only maintain their wealth on an annual basis. Our more aggressive investor is continuing to grow their wealth while they are drawing down on their investments.
It will help in our understanding of compound interest to look at a real-world example. Even though Warren Buffet is one of the richest people in the world, he is a great example to the everyday investor on the power of compound interest. He has lived a long life while maintaining an aggressive portfolio allocation in almost entirely high-value stocks. At the age of 59, Warren Buffett was worth $3.8 billion, which is a staggering amount of money. He could have called it quits and thrown all his money in government bonds and just spent his days on the golf course. However, he wanted to grow an even greater net worth he could donate that could make a difference all around the world. Warren Buffett is currently 91 years old and is worth $115 billion. By keeping his investments allocated to equities, he has allowed his investments to compound for an additional 3 decades. Around 97% of his current net worth was acquired after he turned 59.
Let’s look at one final example. A young couple has their first child and wants to immediately start investing for their child's future, so they start a college savings account and open a bank savings account for their child. They also have an idea about investing money in their child's name using a custodial account. This type of account would let the parents open an account in their child's name and invest in investments such as the S&P 500 (the broad stock market). Once the child becomes an adult, the child will take over the account. The parents plan to invest $100 every month into their child's account until their 18th birthday. When the child turns 18 the money will now be in their child’s name and can be used however the child sees fit. If the investments can grow at 8% a year the child will have close to $50,000 on their 18th birthday. The parents would have contributed $21,600 and the principal would have grown to a total of $50,000. Now let’s say that $50,000 is left in the S&P 500 all through that child’s adult life, and no more is added to the account and no money is ever withdrawn. When the child eventually turns 60 that money could be worth $1.25 million if they can compound their investment at 8%/year. A total investment by the parents of $21,600 has the potential to grow to $1.25 million if given enough time. As the famous saying goes, "It is not timing the market that matters, it is time in the market". As that example shows, having 60 years of compounded investments can turn a smaller amount of an initial investment into a fortune.
Convexity Investments LLC | Naperville, IL | www.convexityinvest.com
Convexity Investments LLC is a registered investment advisory firm. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Past performance is not a guarantee of future performance.