Compound Interest: One Percent Can Make All the Difference
Published on - August 27th, 2009 (by J.D. Roth) How many of you consider the effects of compound interest (or “compound returns”, if you prefer) when you make financial decisions? I mention the concept from time-to-time — and I’ve even devoted whole articles to the extraordinary power of compound interest — but I don’t know if others keep the notion in mind when they work with their finances.
When I was younger, when I was struggling with money, I only had a fuzzy notion of how compound interest worked. Well, I knew how it worked, but it seemed abstract, as if it had no relevance to my own life.
Now, though, I often keep compounding in mind when I make financial decisions. As I make choices, I actually visualize little graphs in my head. (I’m a geek, what can I say?)
I was rummaging around Money Rates yesterday while researching my post on how to find the best bank accounts. During the process, I found an interesting compound interest infographic about how one percent can make a huge difference in retirement savings:
This infographic does a great job of demonstrating just how powerful compounding can be — and how important it is to get the best rates possible:
By spending just a little effort to find the best interest rates, the Wynns keep their money working harder for them…The 1% difference in interest rates ended up giving them 38% more in annual retirement income!
As I’ve mentioned in the past, I’m not a rate-chaser. Not yet. But sometimes I wonder if I shouldn’t be. Especially as I begin to build wealth, even one percent annually can make a huge difference in my nest egg. (Right now, it doesn’t really make sense to chase the highest bank rates, either. Everyone’s rates are low. But in a few years, as interest rates rise, I expect to see greater differentiation between various banks.)
This is also something I consider as I begin to invest more of my money. I understand that the historic returns of the stock market are about 10% annually. But I also know that average is not normal. Like everyone, I want the maximum possible investment return with the minimum possible risk. I know that if I can get 12% annually, I’ll reach my goals more quickly than if I get 8% returns.
But I look at how many people were burned during the recent stock market crash, and it makes me think that the risk of reaching for 12% might not be worth it. With proper diversification, and by being conservative with my money, maybe I can obtain decent growth without risking my savings.
It’s a tough balance to achieve because — as the Money Rates infographic show — one percent can make all the difference.
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The only thing that you didn’t mention was that your money can also be impacted by an 1% increase in fees. When selecting funds, be careful of the fees associated with that fund. Lower fees = more money.
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You need to look at the variability of returns compared with their mean returns over various time scales.
If you look at the distribution of day-to-day returns for the S&P 500, it’s very wide compared to it’s mean. If you look at year-to-year returns, it’s much, much narrower. If you stretch the period to 3 or 4 years, it looks fairly safe to me. And for retirement savings, you’re usually looking at decades.
If you fix the standard deviation of the final result, the mean return rises with the time horizon.
How far you push towards that 12% depends completely on your time horizon.
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J.D.
Aren’t we continue to try to get maximum potential growth with minimum risks? I think a lot of people are in the same boat with you and yes, proper diversification can help. For me, I increase my risks level on the equities side by investing more toward small cap, value, emerging market, but on the fixed income portion, I stick with short term to intermediate term treasury and TIPS. Awhile back, you have a post about Paul Farrell’s lazy portfolio column and you also has a link to FundAdvice.com column The Ultimate Buy-and-Hold Strategy (http://www.fundadvice.com/articles/buy-hold/the-ultimate-buy-and-hold-strategy.html). One thing I like about FundAdvice.com model portfolio is I have understanding of their suggested portfolio based on their article. It shows how different diversification can create higher potential return while maintaining the risks. Of course it is based on past performance, which is not indication of any future performance.
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+1 on what liz says about fees. Lowering your fees is the easiest way to increase your total returns over time. This is one of the most overlooked topics when it comes to investing for your future!
-Gen Y Investor
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People don’t seem to understand the risks involved with investing. People don’t think their investments can actually be negative. I wonder if anyone besides me totally lost money trying to invest? Apparently not enough given the tremendous enthusiasm that everyone seems to have when they talk about how they have so much time to invest so losing money now is not a big deal. I beg to differ. I fell into that marketing ploy of compound interest. They never tell you that you can lose money. Well 15 years later my investments were in the negative. I figured that was long term enough. Now I just stick the money in savings, happy to see it as is and not to worry about losing what I put in. To those who scream inflation I tell them I’d rather lose value than my principal.
-Gen X Investor
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I love how 1% makes the difference between being forced to sell your car and live with your children versus having a luxurious lifestyle with first class travel and a fancy car. Seems like the visual is relying more on emotional impact (i.e. fear) than logic.
I’m not American so I’m not sure about the numbers, but is $54,000 a year really that bad? (Especially when you own your own home?)
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I don’t think compound interest is all that great. Compounding is great for the people you owe money to. Then they get a bunch more than they would if it were simple interest. But in terms of investing, 12,000 dollars at 2% simple interest is 12,240. But if you put 1,000 in the bank every month, and the interest is compounded monthly, for example, at the end of the year, you only have 12,130.80.
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@ Jane, sure compound interest isn’t as great if you’re only using a savings account that’s paying you 2% interest per year. The real benefits come from investing in stocks and bonds over the course of decades which give you a return in the range of 7 to 10%.
@Stackingcash, investing definitely comes with risks. That’s why one must take serious time to educate themselves so they don’t fall victim to the markets. Buy and hold for the long term works only if your buying at a fair price. Some people definitely are better off putting their money in CD’s and other safer investments.
-Gen Y Investor
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Rate-chasing may still not be worth it because it takes a certain amount of work every year to keep up with the highest rate. The amount of time is basically fixed (overhead) but the return you get for the time varies based on the amount you are moving and the difference between the top rate and a consistently above-average rate. If you have a lot of money at stake it is probably worth the time, if you have a small amount it’s probably not worth much effort past finding an initially decent account, and if you have something in the middle it depends.
The point here is not to be specific about rate chasing, but rather the general point of: in a sense, compounding only counts if you are putting something somewhere and leaving it alone.
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@Stackingcash – as Gen Y Investor mentioned, investing come with risks. And I will say this, you WILL lose money investing. There are years that will end up to be negative. Do you mind saying where do you invest your money? Is it in passive index funds or individual stocks? Do you have some money put in high quality bonds, such as treasury bonds? I believe bonds has a place in everyone’s investments, even for a young individual, simply for emotional purposes during the time when the market is down.
Furthermore, how about dollar costs averaging? Do you regularly invest your money, no matter whether the market is up and down? I worry that you have been trapped by marketing put by the like of CNBC or Jim Cramer.
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Hi JD,
Something that really hit home the power of exponential returns was this lecture on growth. The setting here isn’t exactly finance-related, but the math is the same:
http://www.youtube.com/view_play_list?p=89CE288CBAEF46BC
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I think it’s worth noting that if you had invested $10,000 into an S&P 500 index fund in Feb. 1998, you’d still have… $10,000 (discounting any dividends and fees, of course); over a decade passed and you’re back to square one. Ugh.
Since 1998 we’ve had a number of bubble markets. Rocket-wide up, rocket-ride down. Look at a chart of the S&P 500 since the Depression (the Great one, I mean) and it’s pretty steadily, slowing slogging up, til the “new economy” nonsense sparked the first equity bubble, then when that blew up the Fed helped blow the housing bubble to duck the fallout from the tech bubble, then when THAT blew we had the short speculator-induced oil bubble (thanks, Goldman Sachs!).
Beware the next bubble, though I’m unsure what’s left that could actually spark one.
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@ David:
The next bubble is gold.
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@Mr. Bee – MoneyChronicle:
I agree with your idea that bonds are for investers of all ages. I just turned 33, and now invest ~15-20% in a US Treasury Intermediate fund. When my stocks tank, the Treasury bond fund tends to go up and vice-versa. It lends me a bit of sanity after the past two years of pain. My diversification pays closest attention to yields and dividends these days, which most charts don’t take into account. I’m aiming for around 9% as my long-term 30-yr average.
@David:
Your thoughts regarding 10K into the S&P in 1998 don’t take into account dollar cost averaging via additional contributions (no matter how small). If you input the variable data of the swinging cost of shares in the index fund along side the swinging returns/losses, I believe your ending account balance would be greatly increased. However, this does assume that most investers don’t just set-and-forget.
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You said: “But I look at how many people were burned during the recent stock market crash, and it makes me think that the risk of reaching for 12% might not be worth it.”
I believe in the buy-and-hold model. I’ve been putting my retirement into a low-fee stock index fund since 2002. During the loss, I think my investments were down as much as 30%. I did nothing. Now, they’re back in positive territory. I understand how if you sold at a low, you got burned. But if you hung on, did you really get burned? I mean, I’m sure my balances are not as high as they were/would-have-been, but I have recently gotten to a point were I haven’t lost anything (and have some gain).
So has it really been that bad?
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Emily,
While you may think that your low fee stock index fund has rebounced into the positive, you may find that if you backtrack to Aug 2008 to now, you still have lost money. However, instead of -30%, you may be down to only -10%.
It will take you 60% to get back your loss of 30%…
So yeah, I believe that even if you have not sold,(I didn’t either) regardless, we still got burned. Just not as bad as some…
Sincerely.
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Richard, your point is a good one, but it’s overstated… It takes a gain of roughly 43% to recover from a 30% loss.
Start with $100. If you lose 30%, you now have $70. To get back to even, you have to gain $30, which is 30/70 = 0.429, or just shy of 43%.
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Compound interest is a great thing. It works for you when you save money and against you when you borrow it.
The problem is that the stock market doesn’t return a steady percentage return. It has swings up and down. It has periods when it well outperforms anything else and it has periods when you can lose your shirt in it.
Think of a lost decade? You mentioned the compound interest issue but it only works really well over a LONG period of time.
http://www.askthewealthsquad.com/blog/stock-market-prediction-year-2009/
Don’t expect average returns for the next few years. Be prepared when P/E ratios return to historic lows. Right now, focus on controlling debt, creating a nest egg in a safe investment, starting a side business, or learning how to play the market, not get played by it.
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Good post. The three easiest ways to boost returns are:
(i) cut costs (as others have pointed out);
(ii) make sure all of your money is working for you. Small amounts sitting idle in the coin jar or no interest cheque account do add up over time: http://aprivateportfolio.blogspot.com/2006/08/principle-10-small-things-are.html
(iii) paying off any debt which is costing you more than the target annual return (after taking into account tax effects)
If you want to do better you have to beat the market over the long term. Good luck with that.
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Agreed on the fees issue. I made the switch from some Dreyfus index funds (0.5% in fees) to Vanguard (~0.12% in fees) and I know that it’s going to make a huge difference over time.
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@Jane (#7):
“12,000 dollars at 2% simple interest is 12,240. But if you put 1,000 in the bank every month, and the interest is compounded monthly, for example, at the end of the year, you only have 12,130.80.”
Jane, that’s a very disingenuous example. In your simple interest example, you’d have to put the ENTIRE $12,000 in the bank all at once, at the very beginning of the year. In your compound interest example, however, you’re trickling the money in every month, such that you haven’t committed your entire $12,000 until the very LAST month.
So of course there’s going to be a difference in the end value. However, there is also such thing as the “time value of money,” and that’s what’s accounting for the difference here.
A more “apples-to-apples” example would be to compare putting the entire $12,000 in the bank at the beginning of the year for BOTH examples, then calculating the difference (with the compound interest calculated monthly, as you stated). In this case, the simple interest still produces $12,240. However, the compound example produces $12,242.21.
Compound interest wins, by $2.21. Not much, but this is over an extremely short time scale. Over time, compound interest’s advantage widens exponentially, just as conventional wisdom has long claimed.
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I am in the process of building a CD ladder to take advantage of compounding. Fees and taxes do eat into the final value
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@Jane(#7)
The power of compound interest doesn’t show up in a year or two. Consider 20 years though:
Say you start with $1000 and get a 10% rate of return for 20 years compounding monthly your total is $7,328.07 without compounding you only earn $3000 ($1000 + $1000*0.1*20)!
The reason compounding is so powerful is that over time the interest grows to be larger than the initial investment at that point you REALLY want to earn interest on that interest.
-Rick Francis
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That’s very interesting. A lot of my friends and family scrambled to refinance their mortgages when subprime hit the fan last year and rates tumbled. They all bragged that they got a “really good deal” and I believe them, especially after taking a look at that infographic. But for my wife and I, I think it wouldn’t have been worth it. We plan on moving in the next 2 or 3 years, which, I figure isn’t enough time to re-coup the origination fees, etc. Maybe I was wrong, though.
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As always, the decision to chase rates or not (particularly in the stock market, where the diminishing marginal returns of greater risktaking kick in) is a matter of what you want your money for and the relative value of money to you. If you have enough money to meet your goals comfortably, why take extra risks? Money’s not an end in itself.
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One of the big problems in stock investing is that people have a natural desire to look at the bright side and to ignore the dark side. Losses hurt far more than most people realize. When you lose money in stocks, you lose not only the dollars given up but the compounding on those dollars for many years to come.
People often don’t like to hear this sort of thing. It hurts. But accepting that hurt can make you a far more effective investor and can permit you to retire many years sooner than if you continue kidding yourself about the effect of losses.
Rob
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$100 placed at 7 percent interest compounded quarterly for 200 years will increase to more than $100,000,000 – by which time it will be worth nothing.
- Robert A. Heinlein
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Great article. Very few people understand the power of compounding interest. Albert Einstein said it was the most powerful thing on earth. 1% makes such a huge difference! With conservative options trading I shoot for making 4% a month, but have a plan on paper showing 2%. 2% a month compounded throughout the year will give you 26% annually! 1% is a little more than 12%! That’s such a big difference! People need to put it in a graph and play with it to understand it’s power.
http://www.ingnz.com/WEB/webm.nsf/CompoundInterest?OpenForm
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@Beth (#6)
There is an emotional connection but, $20k more a year in retirement by just staying on top of your finances and looking for better yielding accounts, personally I think it’s worth a little research.
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@Brian #13
There may be a gold bubble, but not for a while. I agree with the investor Peter Schiff who thinks gold can get to 3,000 – 5,000 depending on when people realize the dollar is in a downward spiral and won’t hold its value.
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Adam, I totally agree with you about the research. $20,000 a year is a big difference!
I just don’t think the scenarios are realistic. Does less than $2000 a month make the difference between losing your home and enjoying luxuries? If we assume the Zinns are struggling at $54,000, then the Wynns are going to need more income just to keep their home, cars and country club membership. Maybe they need $60,000 or more instead?
So where does the money come from to go on first class trips (easily $10,000 for two per trip), pay for a wedding ($15,000-$20,000) and buy a convertible ($30,000)?
Logic says $20,000 is a big difference. However, the scenarios just don’t add up and I think they undermine the impact of the chart.
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The problem I see in all these compound interest examples is they assume a steady, nonfluctuationg rate of return for many, many years. There is no real solid investment that produces such a thing at rates greater than 2-3% above inflation, and most of those tie your money up for a significant period of time over which inflation varies enough so even that’s not a solid guarantee. So it’s all a pretty picture, and should be used to guide your decisions when considering investments, but the rate shouldn’t be your only factor in making an investment decision. Fees, liquidity, risk, return, among many other factors should be looked at. A good example was chasing rates on a home mortgage. Someone already mentioned that it didn’t make sense for them because they plan on moving in a few years and would be unlikely to recover closing costs over that time. That’s a perfect example of where chasing a rate might be penny wise but pound foolish in that the better rate could honestly result in your losing money because of your future plans.
I don’t know, it seems the amount of effort (assuming you are spending or have spent some time ensuring you’re making reasonable decisions on your investments) to thoroughly research and squeeze out another percentage point on your investments month in and month out versus balancing things once or twice a year may be better spent in getting a better job or otherwise increasing your income combined with focusing your lifestyle or otherwise decreasing your expenses.
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My Dad told me once: “When it comes to a return on your money, always remember, anything over ten per cent is a gift.”
I’ve never forgotten.
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Is anyone else having a issue computing the math?
I used the formula FV = PVe^in to find the future value of the original principal with n being 30 years. This gives $199,207 for the Zinns and $279,596 for the Wynns.
I used the formula FVoa = (PMT [((1 + i)n - 1) / i])*(1+i) to find the future value of an annuity due. This gives $583,283 for the Zinns and $714,267for the Wynns.
Adding them together I get a total of $782,490 for the Zinns and $993,863 for the Wynns.
So am I missing something or are the numbers off? If you calculate the Zinns amounts using 4.1% instead of 4% you get $788,557. Looks like them meant to say 4.1% instead of 4%, all though I find it odd they didn’t compare 4% to 5% instead choosing 4.1% v. 5.13%.
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A more “apples-to-apples” example would be to compare putting the entire $12,000 in the bank at the beginning of the year for BOTH examples, then calculating the difference (with the compound interest calculated monthly, as you stated). In this case, the simple interest still produces $12,240. However, the compound example produces $12,242.21.
Oh, thanks. You’re right. I was comparing apples and oranges. Duh.
What’s even funnier is that when I was doing those calculations some time ago, I was doing them wrong and I ended up with a HUGE balance at the end of the term. I was multiplying by 2% each month, instead of 1/12 of 2%, and I had myself convinced I could retire in 5 years! Ha, ha.
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@beth totally agree scenarios are definitely a little over the top, you may have to play at a crappy country club, and fly business class, forget about the wedding unless it’s like 10 people, what about a mazda miata
I still think it illustrates the difference research can make pretty well. At least for the average joe like myself. I think 1% is low though, proper research should yield more imo.
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I found the graphic a little misleading…the small print at the bottom points out that one example is compounded annually, and the other is compounded daily. So, only part of the difference is the 1% rate difference.
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Compounding interest is a great financial tool when utilized properly. Most people think it’s easy to just leave money and it will compound. It’s not that easy. The biggest mistake people make is not managing their compound interest. The investment companies and people out there market the crap out of it and people end up with huge expectations and think it’s simple. It’s not. Even most advisers don’t fully understand the best ways to utilize compounding interest so they set their clients up to fail.
There’s a good chat on it here: http://financialhighway.com/compounding-interest-best-investment-strategy-invest-early/
I wrote a post on destroying compound interest here: http://evolutionofwealth.com/2009/08/28/destroying-your-compound-interest/
Look forward to hearing thoughts and comments.
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Just to add…if you are looking at compounding interest in a taxable account it is usually (not always) bet to net in that type of account. This is due to the taxes compounding as well. Netting is basically paying the taxes created by the compounding out of the account which compounded.
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The move from a 4% rate to 5% is a 25% increase, NOT 1%. The difference in returns is obviously proportional.
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Did anyone catch the note at the bottom of the illustration?
It reads..”Note: calculation based on 4% compounded annually compared to 5% compounded daily (equivalent to 5.13% annual rate), to reinforce power of compound rates.”
So the Zynns only found a 4% annually compounding rate, but the Wynns found not only a higher % by a point, but also DAILY compounding?…isn’t that skewing the results of the comparison a little to prove a point?
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Steve K has a good point. An experiment can’t have more than one variable. It would never stand up to dispute.
I used the Compound Interest Calculator on MoneyChimp.com and plugged in the Wynns versus the Zinns. If they both had a 5% return rate over 30 years (it’s hard to tell from the graphic), then the Wynns would have about $965,214 with daily compounding versus the Zinns who would have about $964,503 with the monthly compounding. Not a huge difference.
Still, I think this comparison is kind of silly because it assumes everything is going to stay the same for a long period of time — consistent rates, consistent investment, etc. Think of all that’s happened since the 1970s!
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