On Compound Interest, Time Horizon and Average Return
Learn why compound interest is the single most important concept for financial independence
[Disclaimer: I am not a financial advisor and not qualified to do so. I’m a non-professional investor and everything described in this post is based on my experience alone]
As you start reading about investing, you will probably stumble upon the concept of compound interest. As most authors, I believe that the ability to understand compound interest is the single most important variable to develop your plan towards financial independence.
There are three important components of how your interest will compound through time and that will define your future net worth (I’ll also called it “retirement” money):
- the amount you will invest
- the return you will achiave
- your time horizon.
In this post, we’ll dig deeper into the last two, doing some experiments with these two important features when generating compound interest: time horizon and average return. Also, as I want you to get something practical out of this read, I’ll show you the steps of the plan I came up after being aware of compound interest and how that is contributing on my journey towards financial independence.
Let’s do this!
A Dollar Saved in the First Stages of Life is Far More Worth than One Saved in the Latter
There’s no better way to explain this that using a real example. To understand the impact that compound interest may have in your life and investments, let’s do the following experiment — imagine we would divide our life into 5 stages, starting at 20 (a reasonable assumption as most us don’t earn that much money before that age):
- Early Adulthood: 20 to 35
- Adulthood: 35 to 45
- Middle Age Phase 1: 45 to 55
- Middle Age Phase 2: 55 to 65
- Elderly Age: Over 65
Now, let’s imagine that you invest 5.000 dollars in a portfolio for every year of each phase:
So, for every year of “Early Adulthood”, you put in 5.000 dollars. If we multiply this by the number of years we have on this phase (15) we say that we put 75.000 dollars in an investiment during it — to make this simple, I’ll consider that we will put all our money into a basket of stocks that are part of the S&P 500 index.
If you were able to achieve an average return on investment of 10% each year (and this is completely doable as it is just the S&P 500 Average Return in the last 70 years), what would your net worth be like when you are 70?
Yep, not joking — you will have something like 6 and a half million dollars. Don’t believe the math? Use this calculator and check the exact same result.
That’s amazing, isn’t it? First, this is the power of compound interest and how it tends to behave exponentially. Why does it behave in this way? Because the interest that you generate as you go will also generate its own interest in the long term!
Notice that the first 20 years of investing are pretty boring — it’s only after that that the snowball starts to roll and the gains are massive.
But now, let’s roll another scenario — let’s imagine that you have a lavish lifestyle and like to switch cars every year, spending an extra 4.000 dollars on the first phase of your Early Adulthood:
This shouldn’t change much, right? We are keeping the same value for the other phases! So.. what’s the impact on our 50 year return? Let’s see:
We retire with less than half of what we had in the first scenario! The impact of the 4.000 dollar difference on the first 15 years is huge!
But.. will doing the same for the other phases cause the same impact? What if we do the same for the last two stages of our life — Middle Age Phase 2 and Elderly Age? Those two combined also consist of 15 years of our life so this should make a huge difference in the net worth at retiment as well, right?
In the scenario above, we return to investing 5.000 dollars every year of Early Adulthood and only invest 1.000 in the latter stages of life. The impact on the return is…
Minimal! Instead of 6.4 Million, we end up with 6.2 million dollars — I think we can live with that!
But.. if we also changed the amount we invested in another arbitrary 15 years of our lives why did our retirement money changed so much?
Because a dollar saved in the first stages of your life is worth far more than a dollar saved in the latter stages.
This almost has a dilemma ring to it — it’s true that we want to enjoy our lives with the best health possible (and that happens when we are young) but if we end up saving more during those stages we also increase the likelihood of having a phenomenal retirement.
The key here is balance — with this knowledge, you now have the ability to plan towards a phenomenal retirement. I’ll dig a bit deeper into this point in the end of the post. Just know that if you want to start to invest, do it as soon as possible as the first years are crucial for your future return.
The Importance of Expected Return
So, our first take away: time horizon is a key component of compound interest. But, there’s one more key value that will massively change your retirement money — the expected return!
Another experiment, let’s see the impact of adding just an extra percentage return to our average return — instead of 10%, we consider 11%:
With 11% average return, we end up with 9 million in assets by the time we are 70. Amazing!
But of course, achieving an extra point in average return is extremely difficult! A lot of people end up chasing these extra points in yield and end up like Icarus — if you have a proven way to sustainably achieve more than an ETF that follows the SPY (S&P 500 Index) then go for it!
Otherwise, you should keep your money invested in an ETF that follows the total market as it is more important that you keep a steady average return that trying to achieve super high returns that are not sustainable for a time horizon longer than 30 years.
Bottom line is: the other key assumption for these values to work is that your return needs to be sustainable as that’s the underlying rule under the average return calculation.
This should be even more clear if we compare the compound interest generated with three different average returns:
The key here is to focus on the end of each curve:
- With 8% average return, you’ll have 2.5 million dollars by the time you are 70.
- With 10% average return, you’ll have 6.5 million dollars by the time you are 70.
- With 12% average return, you’ll have 13 million dollars by the time you are 70.
What a difference!
The average return is just as important as time horizon. Both variables will define with how much you will have for retirement or financial independence.
The Crux of it All
With this knowledge, the single most important question you have to do to yourself is:
- Why do I want to retire with millions, after all?
While I am a true believer of financial independence, I am also a believer of living life to the fullest while we’re young as health is just as valuable as money. When I was in my 20’s I tried everything I could to save that extra dollar (or euro, in my case), because I knew that a dollar saved in the first stages of life is much more valuable than in the latter stages.
But as I entered into my 30’s I also understood that I was missing out on some experiences and sharing moments with people I cared because of that. And most importantly, I’ve understood that spending money is (sometimes) the best investment there is — for instance, buying lunch to a mentor or someone that you get into your network may benefit you more in the future than any compound interest in the world. I’ll save this last tip for another post!
The key point here is finding out what works best for you — how much can you save without impairing your life’s needs and objectives? And, also, how much can you save and still enjoy your well earned money? Of course, always keep in mind that there’s a huge difference between enjoying your well earned money vs. keeping up with the Joneses mindset.
Here’s the plan that worked for me:
- I’ve defined how much I wanted to retire with.
- I’ve defined when I wanted to retire.
- I’ve made a plan on what was the monthly contribution I needed to do in order to achieve this (with a 10% average return).
- I’ve used the rest of my money to enjoy life experiences and connect with other people —and you know what? This also ended up boosting my income via work opportunities or side gigs.
I’ve been executing this plan since I was 25 and 5 years later this has been working just fine for my personal goals. My average return is 13% (due to bull market conditions) and I’ve been able to enjoy life with my friends and family without overthinking too much about my financial independence. The good part is that, as long as my average return doesn’t go too much below 10%, I’m happy!
I hope you’ve enjoyed this post and I’m looking to hear your thoughts on what has been working for you. Learning about compound interest was an eye-opener experience for me and triggered the development of a plan that maked me think about financial independence less arbitrarily and with more concrete goals.
If you are based in Europe and want to start your plan of investing for financial indepencence with an ETF (Exchange-Traded Fund), you can join Degiro by following this link. I use Degiro to buy total market ETF’s and keep investing the monthly contribution to my portfolio at a really low cost (one of the core features of Degiro’s platform).
