March 31, 2023

Compound Interest: Time and patience do pay off.

If there's one idea that every financial adviser would like to drum into their clients' heads, this is it. Compound interest is the ultimate equalizer. It does not care who you are, where you come from, or what you do. It will relentlessly work for you or ruthlessly punish you without regard. It's about discipline and time and is a tool that works regardless of whether you're a sales clerk at Target or a hedge-fund manager.

It's all about how we earn interest on our investments or pay interest on our debt. Let's say you make 10% this year on a portfolio of $1,000. At the end of the year, that portfolio will be worth $1,100. That means that when you earn interest next year, you'll be doing so on a more considerable amount of money without investing a single extra dollar. As the years pass, you'll earn interest on interest on interest—it's as if a snowball rolling downhill has become an avalanche. That's the reason people often refer to the "magic of compounding."

This tool is potent for younger investors. There is a classic example that demonstrates this: People who can invest even a small amount of money for only a decade starting when they are 18 can end up with a more extensive lump sum by the time they retire than others who invest more but wait to do so until they're in their mid-30s.

If you wait to start investing until you're 30 but then set aside the same $5,000 a year for the next 30 years, on the surface, it looks as if you're doing better. If you can invest $5,000 a year from the age of 20 until your 30th birthday and then don't add anything else, you'll have put aside a total of $50,000. But that $50,000 investment—left untouched and assuming a steady annual return of 7%—will leave you with more than $600,000 by the time you hit 60, while the $150,000 has become about $540,000. Of course, you'll be a millionaire if you can keep investing that $5,000 a year for 40 years, from 20 to 60. Time and patience do pay off.

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