The Not-So Secret Power of Compound Interest

Did you ever sit there and just wonder how did the richest people in the world get so rich?

We have Bill Gates (Microsoft) with $50 billion, Warren Buffett (Berkshire Hathaway) with $40 billion, Lawrence Ellison (Oracle) with $27 billion, the Walton family with $21.5 billion and not to mention the mighty Mr. Moneybags (that would be me) whose net worth is so large that any calculator in the world would simply explode just by trying to fit all those numbers onto one screen.

Let me tell you a little secret: Bill Gates didn’t make that $50 billion from selling bits of string (or computer software for that matter) nor did the Walton family make all their cash from selling mountains of discounted Tupperware (or whatever it is that Wal-Mart sells). I can also guarantee you that there weren’t any (or at least, not that many) shady business deals going on in dark allies next to any dumpsters. All these people made their massive riches through the little gift from the deepest, darkest depths of Rich Man’s Heaven known as compound interest.

What is compound interest you ask? Well, Albert Einstein describes compound interest as the most powerful force in the universe.

Yes, you read that correctly. Not radioactive congenial congruently concentrated vernacular waves, not subatomic dilating hydrogen splitting atomic protons and not even the deadly hydro-synthesizing corrugating sub-congenial metamorphosing radian. He said compound interest.

So, how could the man that was fundamental to the development of the second deadliest weapon (after my fists) the world has ever seen (a.k.a. the atomic bomb) call something that can never harm a fly be the most powerful force in the universe?

You’re going to have to understand what compound interest is in the first place.

Compound interest is making profits on top of profits on top of other profits and so on. As simply as it can be described, it is generating earnings from previous earnings. Before your head explodes, let me formulate it into something a little more tangible:

The story of compound interest

Let’s say your dear old Uncle Bert takes one too many trips to his local buffet and his intestines implode rendering him six feet under a short while after. In a weird twist of fate/luck/insurance fraud you find yourself inheriting a million bucks. You have the following options:

a) Buy a (large) house

b) Buy twenty Corvettes

c) Buy four million sticks of gum

d) Do something useful

Let’s assume you chose option “d”, do something useful – you start your own business. You take the money and you build a stable and start breeding Equestrian racing horses (don’t ask me why, you’re the one that decided to do this, not me). At the end of the year you find that you have made a tidy $300,000 net profit (a 30% rate of return). Instead of spending the proceeds on hookers and booze you decide to reinvest the money back into your business like a good entrepreneur – so now you have $1,300,000 invested in your business.

A year later you find that your rate of return is 30% again –only this time you make $390,000, not $300,000. You made $300,000 from the $1,000,000 and another $90,000 from the $300,000. Let’s say you decide to reinvest these new proceeds back into the business like last year – now you have $1,690,000 invested in the business.

Next year you make another 30% off of your investment – an extra $507,000. You reinvest it and your business is now worth $2,197,000.

I can go on, but I think (or at least, hope) you get the point.  This is what it means to make profits off of your profits.

Oh, and how much do you think that initial investment of $1 million will be worth ten years later growing at the constant rate of 30% a year? $10.6 million. In 27 years it will be just under $1 billion dollars.

And that, my friends is how the richest people in the world got so rich.

By the way, investing in the stock market works the exact same way – that’s how my uncle’s mother’s cousin’s grandfather’s niece’s husband’s nephew, Warren Buffett got so rich (currently the second richest person in the world) and is the predominant source of my income (investing and compound interest, not Warren Buffett).

As I mentioned earlier, the beauty of investing is that your rate of return doesn’t depend on your business skills, but instead on others’ business skills.

A Few Numbers

Let’s have a look-see at what your initial investment of $10,000 can turn into after a few years growing at a rate of return of 30%:

Year 1: $10,000.00

Year 2: $13,000.00

Year 3: $16,900.00

Year 4: $21,970.00

Year 5: $28,561.00

Year 6: $37,129.30

Year 7: $48,268.09

Year 8: $62,748.52

Year 9: $81,573.07

Year 10: $106,044.99

Year 11: $137,858.49

Year 12: $179,216.04

Year 13: $232,980.85

Year 14: $302,875.11

Year 15: $393,737.64

Year 16: $511,858.93

Year 17: $665,416.61

Year 18: $865,041.59

Year 19: $1,124,554.07

Year 20: $1,461,920.29

Year 21: $1,900,496.38

Year 22: $2,470,645.29

Year 23: $3,211,838.88

I’d say that’s not bad – all done without leaving your chair! A lot of you will be somewhat awestruck as to how I can possibly suggest a 30% rate of return – but I assure you, making 30% returns is completely average. My stock portfolio is currently making a return of 144% – and if I can achieve returns like that then anyone can.

Also, just to see what’s out there, let’s see what your initial $10,000 investment could have grown into if it were sitting in a savings account at a bank (nowadays the interest rate you get is around 1% but let’s be generous and assume an interest rate of 3%):

Year 1: $10,000.00

Year 2: $10,300.00

Year 3: $10,609.00

Year 4: $10,927.27

Year 5: $11,255.09

Year 6: $11,592.74

Year 7: $11,940.52

Year 8: $12,298.74

Year 9: $12,667.70

Year 10: $13,047.73

Year 11: $13,439.16

Year 12: $13,842.34

Year 13: $14,257.61

Year 14: $14,685.34

Year 15: $15,125.90

Year 16: $15,579.67

Year 17: $16,047.06

Year 18: $16,528.48

Year 19: $17,024.33

Year 20: $17,535.06

Year 21: $18,061.11

Year 22: $18,602.95

Year 23: $19,161.04

Now do you see the value of investing in the stock market?

What if you don’t have a lot of money to invest?

If you don’t have millions of dollars to invest (or even a few thousand) all hope is not lost. Although it is true that it’s better to invest a large chunk of money at once (mainly due to commissions {more on that later} as well as due to market timing), investing small amounts of money periodically is better than nothing.

Here are some numbers that will help you sleep at night:

If you invest one dollar a day ($365 a year) starting today, growing at a rate of return of 30% a year, you end up with: a bit over $20,000 in ten years, a tad under $300,000 in twenty years and over $4 million in thirty years – or you can buy a chocolate bar a day for the next thirty years, be $11,000 poorer and be 730 pounds heavier.

If you invest $100 a month ($1200 a year) growing at 20% annually, you will have $37,850 in ten years, a bit under $270,000 in twenty years and just over $1.7 million in thirty years.

If you invest $300 a month ($3600 a year) growing at 25% annually, you will have $150,000 in ten years, a bit over $1.5 million in twenty years and $14.5 million in thirty years.

Of course, as I mentioned earlier, the rates of return mentioned above are averages and there will always be down years where you aren’t able to make nearly as high of a return – then again there will also be years you will make returns many times more than that.

Closing Thoughts

The most important thing to remember about the stock market is that the longer your money is invested, the more it grows thanks to compound interest. That’s why it’s so important to start investing your money as early as possible, especially when you see by how much your money grows in the later years.

It’s also important to remember, investing doesn’t have to be a full time job. You can still keep your lucrative job as a potato peeler and do what you love; your money will still be working for you. Of course, it takes some time to research the stocks you are going to buy and then a few hours out of your week to keep up with the latest news.

Then again, it’s better than mowing lawns or sweeping floors.

Mr. Moneybags is the richest being in the universe to ever have existed and ever to exist. He writes about building wealth in the stock market, business and personal finance on his blog and is determined to prove that the subject of money shouldn’t make you want to douse yourself in gasoline and run into a forest fire.

You can find more of his amazing articles on his blog at http://www.BigFatMoneybags.com

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