November 14, 2024 | Quiet Counsel | 6 min read
The Superpowers of Compound Interest
Albert Einstein once said, “Compound interest is the 8th
wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” This is very high praise from one of history’s greatest minds and it may lead you to wonder “What is compound interest and how do I ensure I’m on the winning side of it?” In this edition of Quiet Counsel, we will answer these questions and more.
What is compound interest?
Compound interest is interest earned on both the initial amount of invested principal and on the interest previously earned on the initial investment amount.
What does that mean?
Have you ever stood on the top of a snowy hill and made a very small snowball? If you roll your snowball down the hill, you would see it grow bigger and bigger as more snow packs on. The larger your snowball grows, the more surface area there is for snow to adhere to and your snowball will begin to grow exponentially.
Compound interest works in very much the same way. You make an initial investment and as you earn and reinvest the interest, your investment grows larger and that bigger base is then able to earn even more interest. This effect compounds over time and allows your investment to grow exponentially.
An Example
A stock’s return can be broken down into earnings growth (how much the stock increases in value) and dividend income (the dividends paid out by a company). Let’s first look at the power of compounding interest assuming for now that you allow your initial investment to grow but pull out and spend any dividends.
If you were to invest $100,000 into the stock market for one year and stock prices rose 6%, your portfolio would grow by $6,000. If the following year you left the full $106,000 invested in stocks and prices rose another 6%, your portfolio would rise $6,360 to $112,360. The dollar return would be higher in the second year because you are generating returns on both your principal investment ($100,000) and on the gain from the first year ($6,000). If you continued to let the portfolio compound on itself at the same assumed 6% your savings would grow to $574,000 over 30 years without you having to make any additional contributions.
Figure 1: The power of compound interest – $100,000 compounded at 6% per year
That original $100,000 would grow to nearly $1.9 million over 50 years if left untouched. Sounds impressive, right? Let’s look at how dividend reinvestment can affect these numbers.
The Impact of Dividend Reinvestment
Unless directed otherwise, we reinvest stock dividends back into Leith Wheeler client portfolios. Assume 6% price returns from equities, and that an additional 2% may be generated from dividends. The compounding effect of reinvesting those dividends can be very large over time. Figure 2 shows the difference between a portfolio that reinvests dividends (and so earns a hypothetical 8% per year) versus one that pulls them out (earning 6%). After 30 years, the reinvested portfolio would grow to over $1,000,000 versus $574,000 from the one that didn’t reinvest. Expand the timescale to 50 years and it becomes even more pronounced: an ending value of $4.7 million versus $1.9 million.
Figure 2: The Compounding Power of Dividend Reinvestment
The Importance of Starting Early
Compounding interest works increasingly well over time so the more time you give it to work its magic, the more lucrative it will be. You can’t get the benefits of the 50th year of compounding without building through the first 49 years of growth. So, what can you do?
We often offer this advice to our clients’ kids in their twenties or even their teens: start as soon as you can! Even if you can only set aside a little each month, get it invested and let the markets do the work for you. It’s not something you can cram to catch up later.
Consider the following example: Marta invests $5,000 in the market at age 25 and then adds $2,400 every year until she turns 65. Mario waits until he’s 40 to start investing. He puts $15,000 into an investment account and then tops it up with $5,000 per year until he hits 65. Assuming both earn 8% average returns per year, Marta will contribute 40% less over her lifetime but end up with over 55% more ($789,000 versus Mario’s $506,000).
Figure 3: The payoff of investing early and often
The Impact of Taxes
Both Marta and Mario could have used tax-sheltered accounts such as RRSPs or TFSAs for all their investing. Given these accounts allow gains and income to compound unmitigated by taxes over your lifetime, this sheltering is in itself a tool in your compounding toolbelt. We therefore always encourage clients to maximize these “registered” account options before investing in taxable accounts.
Set It and Forget It
In the above examples, we had the benefit of using fabricated investment markets with guaranteed, smooth returns. Unfortunately, in the real world this is rarely the case as markets refuse to follow our instructions and instead fluctuate over time. Years like 2021 giveth while years like 2022, taketh away. In those down years, it can be tempting to hunker down, sell “risky” securities and build up cash reserves. History shows this is generally exactly the wrong thing to do, at exactly the wrong time. The reason, you may not be surprised to learn, is compounding – and its related cousin, weird math.
What is weird math? If you lose 33% of the value of your portfolio, you need to earn a 50% return to get back to your starting point. Down 50%? You need to double it, or grow 100%!
If you believe as we do that over the long term, markets will rise, it follows that periods of steep decline will be eventually reversed. If you bail out and are not invested when those reversals happen, you can very quickly get left behind. You need those green bubbles to help your portfolio compound back up and recoup losses.
How you avoid these kneejerk mistakes is having a plan before the red bubbles appear. Set your portfolio up in a manner where you know in advance you feel comfortable riding the market highs and lows (because you know your goals will still be achievable). The power of compounding works best when it is not interfered with.
The Flip Side
Unfortunately, compound interest can also work against you. If you maintain an outstanding balance on consumer debt such as a line of credit or credit card, the amount you owe will also compound up over time. That’s because the interest you owe is calculated on both your principal debt and on any previous interest you’ve accrued. It becomes interest on interest (in a bad way). While it may seem generous of the bank to offer you a “minimum payment” option of $10 per month, that grace is insincere. Consider how fast compounding can work against you:
If you pay just the minimum $10/month off on a $5,000 outstanding credit card balance that charges 20% annual interest, your debt will grow to $11,500 in 5 years and to $27,800 in 10 years. The interest you’d be incurring in year 10 would be nearly $400 a month alone.
In short: pay off any high interest-rate debt earliest and don’t carry a balance at all if you can help it.
Key Takeaways
- Compound interest is a very powerful tool and it can either be your savings superpower or retirement kryptonite.
- There isn’t a lot you can control in the markets, but partnering with an experienced investment manager who charges reasonable fees and can help you build an appropriate long-term plan, is one of them.
- The best way to make the most out of compounding interest is to start saving early and give the compounding effect a long runway.
- Compound interest can work just as quickly against you as it can for you. Ensure you are not on the losing end by carrying significant amounts of compounding debt.
