|Summary: Compound interest is a powerful investment strategy, but few use it to its maximum potential. An average income earner can build up $1 million in savings, investing 10% of their after-tax income, and increasing annual contributions in line with inflation, after 38 years.|
|Key take-out: Switching in and out of investments means you run the risk of below average returns, you incur tax and trading costs, and you are getting in the way of compounding.|
|Key beneficiaries: General investors. Category: Growth.|
Compound interest is a force so powerful, it even caught the interest of Albert Einstein.
In fact, Einstein is understood have said: “Compound interest is the eighth wonder of the world. Those who understand it, earn it ... those who don’t ... pay it.”
Indeed, if you had invested $15,000 into Australian shares 40 years ago (starting January 1, 1973 through to December 30, 2012), and had earned nothing more than the average market return of 11% a year over that time (source: Vanguard) it would have turned into $1 million.
Admittedly, $15,000 took a lot longer to earn in 1973 than it does now, but this example still demonstrates the remarkable power of compound interest. (The average full-time income was around $7,500 in 1973. Compound interest turned a sum equal to two times annual full-time into 13 times average full-time income by the end of 2012).
The question then might be, why don’t more people benefit from compound interest? What is it that keeps many people from filling their pockets with the benefits of this so-called “eighth wonder”? Before considering these questions, it is worth looking at exactly what ‘compound interest’ is.
What is compound interest?
Compound interest is the interest earned on interest. The longer you have an investment and re-invest the interest, the greater the pool of money that is earning interest. It is probably best explained through an example.
Let’s assume that you have $2,000 invested in a cash account paying 10% interest (not realistic at the moment – but easier for my calculations). After the first year you earn $200 in interest. Assuming that you re-invest the interest, in the second year you are now earning 10% interest on your original $2,000 and an extra $20 interest on the $200 interest that you earned in the first year. That is, there is extra interest in the second year earned on the interest from the first year.
This continues – more and more interest is earned each year, as the ‘interest on interest’ effect grows.
An interesting way to consider the effect is to think about how long the original $2,000 takes to increase by a factor of $2,000. It originally takes seven years for the initial $2,000 to double. However, by the time the portfolio has been compounding for about 20 years, it increases by nearly $2,000 every year.
Time Taken for a Portfolio to Increase at a 10% Earnings Rate
Years to increase by a factor of 2 (double):
Years to increase by a factor of 3 (triple):
Years to increase by a factor of 4:
Years to increase by a factor of 5:
Years to increase by a factor of 6:
Years to increase by a factor of 7:
Years to increase by a factor of 8:
Years to increase by a factor of 9:
Years to increase by a factor of 10:
Why do many people miss out on compound interest?
The line as you walk past a newsagent on the day of a big lottery jackpot would suggest that many people are hell bent on a quick way to make their fortune, rather than relying on the far more reliable riches that compound interest has to offer.
Given the long-run return from growth assets like Australian shares and residential property, over a working lifetime all people would need to do to end up with a significant pool of wealth is save money regularly (especially early in their working life, so that the savings have plenty of time to be compounded through investment earnings).
I believe that two things stand in the way of people successfully tapping the potential of compound interest for themselves – a lack of patience and overconfidence.
A lack of patience impacts many people who put in place a saving/investment plan – expecting it to lead to great riches through the benefits of compound interest. Often they have read articles about the impact of compound interest, used a calculator to work out how much money they should have from a regular saving plan or have been encouraged by an advisor.
However, the reality of compound interest is that its power lies in the long term, 15 years or more, and so people who enter into a saving/investing plan with high hopes are often disappointed. However, let’s use a different approach to looking at progress towards long-term financial goals that I think will be more motivating.
Compound interest and progress to $1 million
I have set up a calculation to chart the progress of an average income earner to the sum of $1 million in today’s dollars. My basic assumptions are that the person in question:
- Earns the average full-time income – which is $57,300 a year after tax.
- They save 10% of their after-tax income ($5,730 a year).
- They earn a return of 7% a year after inflation.
- They increase their annual contributions in line with inflation.
It takes them 38 years, under this model, to become a millionaire in today’s dollars.
What I find very interesting is to look at where they are at different points in the journey:
After 9.5 years and, in terms of length of time, one-quarter of the way to $1 million in today’s money, they will have an investment balance of $75,000. So, $75,000 is actually one-quarter of the way to being a millionaire.
After 19 years, and half-way to $1 million, they will have an investment balance of $220,000. After 28.5 years, and three-quarters of the way to $1 million, they will have an investment balance of $500,000.
I think this shows how challenging it can be to get started on the compound interest ride. Think of the situation after 9.5 years – the people in the example have been committed to a saving and investment program for nearly 10 years, thinking that it will have them well on the way to financial success. Yet the sum of $75,000 seems comparatively insignificant if the final goal is $1 million.
My hope is that by looking realistically at their progress, and understanding that the impact of compound interest is significant later in the life of a saving and investing strategy, they will see that they are much closer to their goal than they originally thought.
Indeed, I suspect that if a lot of people saw that, with the help of compound interest, $75,000 was one-quarter of the way to $1 million (in today’s dollars) they might be particularly motivated to start a saving plan and get to that figure even sooner. Interestingly, this is exactly what we should do to take advantage of compound interest – start early and save hard.
The following table sets up benchmarks for the journey from $0 to $1 million in today’s dollars. It splits the journey by time, into 10 equal portions, each of 3.8 years’ long.
% of the Time Through the Savings Plan
Portfolio Balance in Today’s Dollars
Overconfidence - another compounding killer
A financial services firm in the United States, Dalbar, has measured the returns that investors in shares receive after accounting for the timing of their buying and selling decisions.
They find that investors do a terrible job of switching in and out of the sharemarket – usually capturing less than half of the returns available from the average market. In an article earlier this month (Buffett’s rules for your DIY fund), I looked at Warren Buffett’s advice not to try and do that.
Switching in and out of investments means you run the risk of below average returns, you incur tax and trading costs, and you are getting in the way of compounding, the simple re-investment of income, doing its work.
As much as compound interest seemed to excite Einstein, so many of us don’t get our share of this ‘eighth wonder of the world’. Giving up early can be a common problem, and I suspect many people don’t really see how close they are to being successful. Looking at how far we are in terms of the time towards our goal might help us be more patient, even when it seems that the portfolio balance is not quite as ‘wonderful’ as we had hoped.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.