Albert Einstein reportedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
When it comes to investing, there are two very important keys to success: harnessing the power of compound growth, and starting early. Let’s take a look at each of these concepts, beginning with compound growth. (Note that we use the terms compound growth and compound interest interchangeable throughout this piece.)
Compound interest occurs when interest earned for any specific time period is computed using the original principal plus all the interest earned in all prior periods. That is, compound interest is when you earn interest on your interest. This is unlike simple interest, where you only earn interest on your original principal. Let’s illustrate with an example.
Compound vs. Simple
Let’s consider two investors, Jack and Jill. Both invest $100,000 for 5 years, and both earn 5% interest per year. However, Jack’s earns simple interest, while Jill earns compound interest. In year 1, they both earn exactly the same amount of $5,000, which is 5% of $100,000. And in year 2, Jack still earns 5% of $100,000, which is again $5,000. However, in year 2, Jill earns 5% of $105,000, which is $5,250. By year 2, Jill is already earning more interest than Jack.
While the difference is rather small in early years, it becomes much more pronounced in later years. That is, while Jack earns $5,000 interest every year, Jill earns more and more interest every year. Here’s how the scenario unfolds:
Jack – Initial investment $100,000
Simple interest 5% per year
|Year 1||Year 2||Year 3||Year 4||Year 5|
Jill – Initial investment $100,000
Compound interest 5% per year
|Year 1||Year 2||Year 3||Year 4||Year 5|
As we can see, after just 5 years, Jack has $2,628 more than Jill.
What if this scenario was continued for a total of 35 years? Jack would earn $5,000 interest per year for 35 years, for a total of $175,000 interest earned. His $100,000 original investment would therefore be worth $275,000 after 35 years.
On the other hand, the amount of interest Jill earns each year would continue to increase, and she would earn approximately $451,602 interest over the same timeframe. That is, Jill’s $100,000 original investment would be worth $551,602 after 35 years.
This clearly illustrates the power of compounding – after 35 years, Jill has more than double the amount that Jack has.
Another key to successful investing is to start early. Of course, you have no control over when you’re going to turn age 65, or any other age for that matter. But one thing you can control is your starting point. The key is to start early, so you have as many years as possible to enjoy compound investment growth until you reach your goal.
Let’s consider an example that demonstrates the importance of starting early. In this example, we again have two investors, Matthew and Melinda, both age 25. Both Matthew and Melinda want to retire at age 65.
Matthew starts investing now, at age 25, and contributes $5,000 at the beginning of each year into his Tax Free Savings Account (TFSA). He does this for 20 years, and then stops contributing at age 45. Melinda is late to start her investment program, and begins only when Matthew stops. That is, Melinda starts contributing at age 45, and also contributes $5,000 at the beginning of each year to her TFSA for 20 years.
How does it unfold? First, note that in this scenario, both Matthew and Melinda contribute $5,000 per year for 20 years, for a total of $100,000 contribution each. That is, they both contribute the exact same amount to their TFSA accounts. Furthermore, assume that they both also earn the exact same rate of return, of 7% per year. So how much do they have at age 65?
At age 65, Melinda has a total of $219,326. That’s not bad, considering she only invested $100,000 of her own money, and her account would have more than double that amount by age 65.
What about Matthew? By age 65, he has a whopping $848,722.
Even though they contributed the exact same amount, and earned the exact same rate of return, Matthew has almost 4 times as much as Melinda. Why? Because he started early. Yes, it really is as simple as that.
If you want some help setting up your investment plan to make sure you’re on track, we can help. To have a discussion with a Portfolio Manager or Certified Financial Planner, just contact us.