The Power of Compounding Interest

Did you know there are 75,708.24 drops of water in a gallon? If I asked an 18 year-old senior in high school to collect 1 million drops of water (~13.2 gallons) at a rate of 100 drops per month, it would take over 833 years to do it. Impossible, right? As a senior in high school, I was fortunate to be offered a life skills class. One of the topics we discussed was how to save money. I will never forget the guest speaker who explained that saving only $100 per month over several decades would make me a millionaire. Assuming a rate of return of 10% annually, investing $100 per month in the stock market from the age of 18, you would be a millionaire by the age of 64 (see the math here)*.

How is it possible that saving a million dollars at $100/month can be achieved in 46 years while savings a million drops of water at 100 drops/month takes 833 years? Money is nothing like water drops. The magic of investing is compounding interest over time. If I invest $100 today at 10% interest annually, I will earn $10. Now, that $100 has become $110, and the next year I will earn $11 (10% of $110 = $11). Now, that $110 has become $121. This may not seem like a great increase, but over time this investment will grow exponentially because every dollar earned increases the original amount on which interest is calculated. As the chart below demonstrates, the longer your money is invested the faster your earnings grow near the end of your investing horizon.

Growth of $100 invested monthly

Source: Bankrate.com

I wish I had listened more closely to that advice when I was 18. So many people reach the age of 40, 50, or 60, only then to realize they should have been saving more earlier on. There are certainly ways for people in the later parts of their career to catch up on retirement savings, but it is a lot more difficult than starting from a young age. The most important factors to accumulating wealth are consistency over time, patience, and developing strong, healthy financial habits from the beginning (and it is never too late to start). Anyone can become a millionaire with these traits!

Let’s face it, investing can be daunting. There is a wealth of information that can scare away young and amateur investors from entering the market. It’s tempting to sit on a wad of dollar bills tucked beneath the mattress, but the opportunity cost of missing out on the power of compounding interest can be far more costly than the losses that money would face invested. It’s not easy to be patient or consistent, but faithful habits of saving over time can yield massive rewards in the long-run.

Notes:

*The S&P 500, an index which tracks the performance of the largest 500 publicly-traded companies in the U.S. has returned roughly 9.5% annually since the Great Depression started in 1929 (Source: http://www.moneychimp.com/features/market_cagr.htm)

Disclaimer: Past performance is no guarantee of future results, which may vary. Investing involves risk, including possible loss of principal. The value of investments and the income derived from them may fluctuate over time. All portfolio returns and scenarios presented are hypothetical and backtested. The opinions and views expressed by the author do not constitute investment advice or recommendation, and are provided solely for informational purposes, and are not an offer to buy or sell any securities.