Beginner Investing: Compound Interest

We’re going to cover compound interest and how you can make your money work for you, instead of you working for your money.

“Compound interest is the 8th wonder of the world.  He who understands it, earns it, he who doesn’t, pays it.”

-Albert Einstein-

Imagine saving a minimal amount of money, but using the power of time to create vast amounts of wealth.  That is exactly the concept behind compound interest and why it is such a powerful force when investing.  I’m going to assume you understand the basics of compound interest in this article.

I like using examples because it gets my point across very vividly and I can connect with real situations.  So we save from age 20 to 40 and accumulate $100,000.  We invest that money in an index fund at 10% with no fees and we just let it sit there for 25 years until we retire.  What happens? Out pops over a half million dollars.  Through the power of time and compound interest we’ve more than quintupled our money.

Another example that I discussed earlier: Theodore Johnson.  A UPS worker who never made more that $14,000 a year retired with over 70 million dollars.  He made a promise early in his life that he was going to save 20% of everything he made, and put it toward investments.  As his nest egg grew, so did the compound interest he was making on his investments.

The best part about compound interest is that it favors the young.  We’ve got a massive leg up on all of the baby boomers because we have so much time to compound interest with.  Who knew that being young could be such an advantage when it came to making money?  The answer: Lot’s of people.  If you ask any investor in today’s market what they would have done differently, I can guarantee a solid margin of them would say they wish they would have started earlier.  All that time lost is something they can’t get back, and the profits on their investments for that time are lost forever.

We’ll cover this in a later article, but simple budgeting and cutting out only one splurge meal a week can help you save that 5,10, or 15% a month that will lead to compounding that interest at a more voracious rate.  Another thing we’ll talk about in later discussions is the fact that the US market has had a consistent growth pattern for decades, and putting your money into index or regular mutual funds is a relatively safe and guaranteed way to grow your investments.

The problems that we run into when it comes to compound interest are: fees, finding an attractive index fund with a low buy in price, and that 5-9% consistent return in the market.  Just like earning compound interest, fees can pile up and compound themselves, that’s why I strongly suggest doing your homework in depth on where you put your investments.  As for finding attractive index funds?  There are plenty of them out there with $100, $250, and $500 initial investment requirements that perform extremely well and I’ll discuss my view of the different ones available for people on a low budget in the future.  Lastly: earning that consistent 5-9% is not easy, but investing in a good whole market fund can help your long term returns.

Some of the concepts we’ve discussed in this piece will be developed further in more detail because they require an entire article and more to explain them and get a good bearing on how to use them to your advantage.  Overall we’ve discussed the upsides of compound interest, and this will be a major talking point for a very long time.  If you have any questions or comments, feel free to email me at David.Coleman@collegeinvestr.com or leave a comment on this post.  Thanks for reading!

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