I am a big fan of compound interest. You can find references to our friend compound interest in many other posts of mine. Those other posts also featured the compound interest calculators that are so fun to play around with.
HOWEVA ————————————————–>
There is something about compound interest that is a huge Bummer. A bummer with a capital B.
It seemingly takes FOREVER to get going.
Patience is Hard
I’ll admit that I’m not always the most patient person. But relying on compound interest requires a lot of patience. That’s because compound interest starts out small and stays small for a while. This feels even more true if you’re early in your investing/FI journey like me. Let’s look at an example, pretending that your portfolio has an investing return of 7%.
With $10, you get 70 cents.
With $100, you get $7.
With $10,000, you get $700.
With $100,000, you get $7000.
With 1,000,000, you get $70,000.
It can take a while until compound interest gives you really serious returns!
Leveraging Contributions
No investor is going to invest $10 today and then never again. The goal is to continue to contribute to investments to help compound interest along the way. Getting more dollars to work for you will only generate more compound interest down the line.
But in the beginning, it’s difficult to keep the final result in mind. Contributing the thousands of dollars necessary to get the compound interest machine cranking feels futile. But while compound interest takes time to get going, it dominates when it takes over. Let’s take a look at an easy example. You take my advice and max out your Roth IRA. How long does it take for compound interest to take off?
Compounding Slowly
It seems to take our friend Compound Interest a lot of time to get going. At year 5, contributions still make up nearly 90% of the portfolio’s value. At year 10, contributions are still 72% of the portfolio’s value.
It seems to take our friend Compound Interest a lot of time to get going. At year 5, contributions still make up nearly 90% of the portfolio’s value. At year 10, contributions are still 72% of the portfolio’s value.
What gives? I thought compound interest was supposed to do the heavy lifting? I’m 10 years into saving really hard, and compound interest has barely lifted a finger! But now a curious thing is happening. Investment returns are now the same amount as the contributions. Compound interest has awoken from its slumber, and will now start working like crazy.
All that saving is going to pay off in spades once we take the long view. Remember that the Rule of 72 shows how long it takes for your money to double, but that it takes a while for that doubling to really count.
At the end of 20 years, contributions are down to less than 50% of the portfolio and falling. All this time, the same contributions are going into the account, but compound interest has taken over. After 30 years, contributions are now less than a third of the portfolio.
Reframing the Bummer
Being in a state of constant impatience with investing is a recipe for disaster. That’s the attitude that leads to very risky investments and most likely losing a lot of money. The best way to combat impatience is to not deprive yourself of what you value in service of more investing. It’s easier to be patient if you still have enough to pay for your hobbies. If I decided to forego escape rooms until I reach FI, I would be miserably counting down the days! Instead, it’s imperative to build a lifestyle based on enough. Here, needs and most important wants are met while still meeting savings goals. It’s not flashy and it’s not quick, but it works.
Want to learn more about investing? Check out some of my other blog posts! For books, I recommend The Simple Path to Wealth and my most recent read: The Richest Man in Babylon (affiliate links).
Compound interest is one of those things that everyone loves but it takes time and patience. Still, it works.
Isn’t that neat? Our market returns exceeded our actual savings last year and that felt incredible. Like an invisible 3rd person in our household, a sudden lift.
Then again, not every year will be a 20% year.
Rule of 72 is a nice reminder.