In this post, I'm going to explore compound interest and show you how to exploit it to build a high level of wealth.
Compound Interest Definition
Compound Interest is interest paid on the initial principal as well as additional interest that was accumulated on money borrowed or invested.
In investing terms, you are gaining interest on the money you originally invested as well as any interest gained through capital gains on your investment.
Compound vs Simple Interest
What set’s the two apart is the way that interest is calculated.
As we know, compound interest calculates interest based on the initial dollar amount as well as interest accumulated on top.
Simple interest pays a flat rate. Meaning $10,000 invested at 10% interest a year for 5 years would give you $15,000 at the end of the term. Receiving compound interest, you would have amassed $16,105.
What Compound Interest Can Do
Compounding can have a dramatic effect over time.
Let's pretend you invested $10,000 in the All Ordinaries Index on the 15th of December 1984. Today, you would have amassed $115,815! At a compounded annual growth rate (CAGR) of 6.26% a year (not including dividends).
To give a better perspective, I will use the S&P 500 for reference. In this case, $10,000 invested on the same date would be $160,684 today! Not including dividends and a CAGR of 8.51% a year.
$160,000 after 34 years might not sound like a lot to some people. But remember, this is with an initial investment of $10,000 and no more. If you invested an additional $10,000 each year, well this number would be quite substantial.
Let's assume you invested another $10,000 yearly with a CAGR of 8.51%. The average return the S&P 500 has provided over the foregoing period. Instead of $160,684, you would now have $1,931,351. With a total savings of $340,000 and $1,581,351 of generated interest!
Compound Interest Chart
Here is what $10,000 would look like when growing by 10% annually for twenty years.
I have included a link to a compound interest calculator here. It is great if you are interested in working out the sort of gains attainable at your savings rate.
Why Stocks Are More Profitable Than Bonds
Investing in stocks is widely considered to be more lucrative than investing in bonds.
Bonds generally appreciate less before their maturity date compared to stocks. Meaning your primary source of income will be from the simple interest received periodically.
Stocks generally appreciate most years. Meaning you will obtain dividend income, as well as experiencing an exponential increase in portfolio value over time.
For a great resource on finance and investing, visit the video uploaded by Big Think below.
The link leads to the point in the video where Ackman explores compound interest, and how it can affect your wealth in retirement. However, I would recommend that you watch the whole video if you have the time—I believe you will get a lot from it.
I have included a snippet of the YouTube video's description below.
William Ackman: Everything You Need to Know About Finance and Investing in Under an Hour.
WILLIAM ACKMAN, Activist Investor and Hedge-Fund Manager