Compound interest vs. increased income — Which matters more?

Compound interest vs. increased income — Which matters more?

Like nearly everyone else on the internet, I’m a fan of xkcd, the nerdy webcomic from Randall Munroe. My wife, who’s a chemist, loves xkcd’s science episodes (such as this and this), while I like everything else (especially this and this). And let’s not forget the map of online communities!

Many of you e-mailed to tell me that yesterday’s xkcd tackled a subject near and dear to our hearts: personal finance. Specifically, Munroe poked a hole in the myth of the magic of compound interest. Sort of. Here’s the comic:

xkcd on investing

I’ve received several messages from readers over the past few months questioning the efficacy of compounding. Here’s the thing, though: Compounding is awesome. And it works. But it’s not a magic bullet. It’s one tool in your financial toolbox, a toolbox that includes Roth IRAs and budgeting and conscious spending. So let’s be clear: A high-yield savings account won’t make you rich. In fact, no single financial tool is going to do that. But used together, you can construct the life of your dreams.

I ran several scenarios through Money Chimp’s compound interest calculator, and here’s what I got.

  • Using the example from the xkcd strip, if you made a single $1000 investment at a 2% rate of return, in ten years you’d have $1218.99.
  • Perhaps obviously, if you started with $10,000 instead, you’d have $12,189.94 after ten years.
  • Using a more life-like example: If you maxed out your Roth IRA every year with a $5,000 contribution to an investment returning 2%, after ten years you would have contributed $50,000 and your balance would be $53,357.28.
  • If you followed this investment program for thirty years, your total contributions would be $150,000. Your final balance would be $210,954.01.
  • Getting more life-like yet, what if you earned an average of 10%, which is the long-term average return for the U.S. stock market? If you invested $5,000 a year for thirty years and were able to earn an an annual return of 10%, your $150,000 would be worth $986,964.14.
Important Note: While the U.S. stock market has returned an average of 10% per year over the long term, shorter investment periods are much more volatile. And, in fact, average is not normal. That is, some years — as in 2008 — the market (the S&P 500 index, in this case) returns -37.00%. Other years — as in 2009 — the market returns +26.46%. The market almost never returns just 10% in a year.

As you can see, you shouldn’t ignore the power of compounding. Compound returns can be (and often are) instrumental in boosting wealth.

Still, Munroe makes a very important point: The single greatest factor in determining your retirement wealth isn’t your investment returns — it’s how much you contribute. In other words, you can’t just throw a few thousand dollars into a retirement account and then hope everything’s going to work out. You have to keep at it. You have to continue contributing. The more you save, the more compounding will work in your favor.

It’s because of this that I’m always harping on the need to increase your income. I’m dead serious when I write that nothing will supercharge your finances like finding a way to make more money. And you know what? For the most part, this is something you are completely in control of. When I say that nobody cares more about your money than you do, this is one of the things I mean. If you truly want to have more money — so that you can pay off your debt, send your kids to college, travel the world, and so on — then the single best thing you can do is boost your income.

But don’t bury your increased income under a rock. Don’t go spend it just because an internet comic strip tells you that compounding isn’t worthwhile. Compounding matters. Make as much money as you can, and invest it wisely so that, in time, the magic of compounding can help to make you rich.

Footnote: As some GRS readers noticed, an episode of xkcd from last week also addressed personal finance. That one’s a little more controversial, though; if I’m going to tackle it — and I might since I agree with it — I need to time to refine my thoughts.
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