Compounding Interest: The GOAT of Personal Finance
Posted originally on 21stfinance.com
Generating wealth is a marathon not a sprint. Get rich quick schemes and people becoming a millionaire overnight doesn’t happen. If you want to become financially free, you are going to have to put in the work and save your money. Warren Buffett is known as the greatest investor in the history of mankind. With a net worth of over $80 billion, he knows the money management skills to create long lasting wealth.
The key to immense wealth and financial freedom is compound interest. Any basic investor needs to know what compound interest is, and in this blog we are going to explore the concept even further.
What is compound interest?
Simply put, compound interest is additional interest on an outstanding sum of principal money. Compound interest is interest on interest.
For example, say you earn a 7% return on a $100 in year one. You earn $7, and your total is now $107. Say that in year two you also earn another 7%. By the laws of compound interest, you earn 7% on $107, giving you a total return of $7.49.
This means after two years, your total value is now $114.49, or a 14.49% return! By applying the compound interest formula (see below), one can see how time greatly impacts this starting principal of $100.
In most retirement situations, investors are looking to grow their money over the longer term horizon. As you can see from the table below, time (years) is the biggest catalyst in growing your funds. After 25 years, an original principal of $100 would have grown 443%.
When you consider that most investors are adding money into these accounts every single month over the course of these years, the percent gains and monetary value of these accounts multiplies even higher.
Now you may be asking yourself, “How do I get started with compounding interest?” The great news is that there are a ton of different ways to harness the power of what Albert Einstein called “The eighth wonder of the world”.
Employee Sponsored 401k
The great thing about these investment plans is that you are really getting two different investment returns here. Many employers will match what you put into these plans while you watch the market grow over time. If your company offers these plans with a sizable match, this investment is a must.
Stocks (invest wisely)
Many companies will pay out dividends to their investors, which can then be reinvested back into the company. When choosing stocks, make sure you perform due diligence. Not all stocks are guaranteed to produce sizable returns.
I personally think this is the best way to invest into the stock market. Mutual funds are set up to mimic the overall trends of the stock market (S&P 500, DOW Jones) by bundling together different stocks from many different sectors. The goal of Mutual Funds is to pair together companies to mimic what returns the overall market will generate. Certain companies, such as Betterment, offer electronically traded funds (ETF) with very reasonable fees.
Compounding interest is the smartest and most effective way to grow your wealth over time. The earlier that you start investing, the greater the returns you will see over time!
If you have trouble investing or are nervous to get into the market because of experience, I recommend these platforms.