By: Brett Sifling
When I studied archaeology in Israel for a summer I became keenly interested in the 7 wonders of the ancient world. From the Great Pyramid of Giza, to the Statue of Zeus at Olympia, there is much to learn from these remarkable creations. However, there is one wonder of the world that needs to be added to the list: The Effect of Compounding Interest.
Thought to have originated with mathematician Fibonacci in 17th-century Italy (Geisst), this magical concept is one of the keys to investing success. In this article, I'm going to show you why it is so powerful and how you can take advantage of growing your money quicker.
When you put money into an investment, you will likely earn interest on the principal amount. Compounding interest is simply earning interest on top of your interest. This means that you will not only earn interest on the initial principal of your investment, but also the accumulated interest over time.
The rate at which your compounding interest accrues, depends on the frequency of the compounding. The more periods that your investment compounds, the faster your investment will grow.
To best illustrate this, we are going to look at an investment that compounds annually. Let's pretend you invest $10,000 today and the rate of return is the long term S&P 500 historical average (11% annually).
After the first year, in theory you would have made 11% on your investment. Your $10,000 is now $11,100. The second year, you now make 11% on $11,100, which results in $12,321. In the third year, you end up with $13,676.31 as your investment compounds on all prior accumulated interest. By year 45, your one time investment of $10,000 has now made you a millionaire with a total value of $1,095,302.42.
Compounding interest is a powerful tool when it comes to investing. While it is unrealistic to expect exactly 11% per year, I wanted to put this concept in perspective for those investors that think they don't have enough money or time to start. The earlier that you start investing, the longer your investment has to grow. It sounds cliche, but time truly does beat money. One lump sum investment today, can make your retirement nest egg worth millions more.
If you are looking to get started investing or haven't filed your taxes yet, give me a call at the office. This concept of compounding interest has been simplified and there are many other strategies that complement it, such as tax efficient retirement accounts. I can help you create a comprehensive plan, establish the right accounts, and pick an investment selection that will help you get to your goals.