If you’ve ever wondered why so many people are obsessed with making money from the stock market or other similar investments, then perhaps you should become acquainted with the power of continuously compounded interest and how it can cause your money to grow beyond any sum you could ever hope to achieve yourself.
Albert Einstein has been credited with calling compound interest “the greatest mathematical discovery of all time”. And he is absolutely right when it comes to practical applications; especially regarding your finances.
Compounding interest is a phenomenon that occurs when the earnings from your investments combine with your original investments (called the principal) to build up larger and larger earnings as time goes on. As you’ll see in the example below, eventually the earnings growth becomes so large that they surpass the original principal contributions and begin to explode at an exceptional rate.
This is a very unique opportunity for your finances because once your portfolio reaches a certain threshold, you could theoretically live off of the residual income that your money earns each year. Unlike other strategies for building passive income, living off the earnings from your investments can be a 100% passive process if you choose to use a good investment such as a stock market index fund.
2 Options – Which One Makes More Money?
To really illustrate the points above, let me start by asking you a question: How much money would you make if you were to invest $10,000 every year for 40 years using one of two options for investing:
A) Under your mattress?
B) In a stock market index fund?
The second option results in almost 6.5X more money than the first? Why is that? That’s the beauty of continuously compounded interest over time. It can result in the potential for more money over longer and longer periods of time.
A Closer Look at How Continuously Compounded Interest Works:
So to understand how we were able to get such a higher number harnessing the power of compound interest, let’s dissect this process just a little bit to see how it works and benefits our efforts at becoming rich.
Option A is easy to understand. You simply take $10,000 each year and put it under your mattress literally (just like they used to during the Great Depression). Because your investment earns absolutely no interest (since your mattress is not the same as bank and doesn’t pay you interest), the math for this scenario is very simple to understand:
- $10,000 x 40 years = $400K
Even though mathematically that’s what you’d have, the truth is that your money would be worth even less than that due to the losses from inflation over that time. In fact, using the rule of 72 and an inflation rate of 3%, your money would be worth half as much after 72 / 3 = 24 years. So after approximately 40 years, your money would be worth about a quarter of the purchasing power it has today! Yikes!
Option B is best understood using an illustrative process.
For the sake of simplicity with this example, let’s assume that your investment earns a straight 8% every year. (This of course never really happens in reality but it will help show how compound interest works in this lesson).
To begin at the end of Year 1, we invest $10,000 and earn no interest.
At the end of Year 2, we invest another $10,000 to have a total of $20,000. The 8% return on our $10,000 is $800 (red), and so that gets put on top of our principal investment (blue).
Now continue this process for 3 more years and we come to the end of Year 5. We’ve invested $50,000 (5 x $10,000) and return on investment has grown to $8,666 ($800 + $2,464 + $5,061). Notice how as our total portfolio amount increases, so does our return on that investment.
Now fast forward to the end of 20 years. Now the amount of money we earn from our total investment (red) actually starts to surpass the total amount of money we initially invested each year (blue).
By the end of Year 40, the power of continuous compound interest has resulted in the returns actually contributing more into the total portfolio way beyond what we originally put into it.
So How Does This Result in Big Passive Income?
How does a portfolio of almost $2.6M help us financially? How about living passively off of just over $100,000 each year! If you follow traditional financial planning tool of using the 4 percent withdrawal rule for retirement, you could allow yourself to take out 4% from your portfolio each year (and then adjust for inflation each year after that). $100K in passive income is no small accomplishment!
To contrast this point, how much money could you withdraw each year using the “under the mattress” saving technique? $16,000 each year – a number that almost qualifies you for poverty. Which option would you have rather gone with?
This is why financial planners almost always recommend starting your retirement savings early and investing as much as you can afford. Clearly through the power of continuously compounded interest and returns, you stand the huge potential of increasing your portfolio by a great deal more and being able to withdraw a lot more money for you to passively live off of.
Images courtesy of FreeDigitalPhotos.net and DW