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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STRONGside
STRONGside
9 years ago

Compound interest plus a large time horizon, might very well be the greatest savings vehicle ever invented. But you are certainly correct, making more money and finding ways to increase your income through multiple and diverse revenue streams is the best way to safeguard your future wealth, and to ensure a happy and secure retirement (or later years, if you don’t ever plan to retire!)

Yieldstream
Yieldstream
9 years ago
Reply to  STRONGside

True, as long as you keep in mind the real (inflation-adjusted) return of your investments, and make sure it exceeds the rate of inflation. That’s the problem with savings accounts at currently available interest rates: your money is guaranteed to lose its purchasing power over time!

Classier+Corn
Classier+Corn
9 years ago

I agree. The increase of income is very important. But if you increase your incom over a large time horizon – it is also very important to not increase your spendings to much over a large time horizon. That´s the hard challange!

Jacq
Jacq
9 years ago

And there’s a sort of compounding ON the increased income if you’re a salaried person too – getting the same annual raise on a higher base income will get you to your goals faster. It’s SO worth it to push yourself a bit out of your comfort zone to get up to that higher level.

sarah
sarah
9 years ago

but… it does say $1219

J.D. Roth
J.D. Roth
9 years ago
Reply to  sarah

Ha. He corrected his error. I’ll remove that paragraph from my post. 🙂

Tom
Tom
9 years ago
Reply to  sarah

I think it was fixed, or JD can’t read Munroe’s handwriting!

Mondo Esteban
Mondo Esteban
9 years ago
Reply to  sarah

Thats what I was thinking.

Justin | Mazzastick
Justin | Mazzastick
9 years ago

I have experienced the beauty of compound interest myself through a 401k.

$8000 of my own money turned into $32,000 in 10 years.

Kevin
Kevin
9 years ago

Wow, that’s a compound annual growth rate of almost 15%! You were VERY lucky! I hope you don’t expect that kind of return to continue indefinitely into the future.

Everyday+Tips
Everyday+Tips
9 years ago

Hey, compounded doesn’t hurt, and every little bit helps. Ideally you would increase your income and invest the money so you have something to compound with!

Pamela
Pamela
9 years ago

Putting as much away starting as early as possible is especially important for people who can not or will not increase their income. Compounding will be their only chance of improving the financial status of their later years. But if all of us made choices to maximize our income so we could count on a secure retirement, we’d have very few writers, artists, musicians, childcare workers, nurses aides, nonprofit workers, clergy etc. And there are only so many side jobs you can work when you’re raising a family and taking a bus 2 hours round trip to your minimum wage… Read more »

Beth
Beth
9 years ago
Reply to  Pamela

Agreed. I’m in a “low paying field” (well, compared to being an engineer or lawyer) but compound interest is just one tool in my arsenal. My retirement savings is in other vehicles as well, and I’m working to improve my career.

I figure savings is one thing, but if I’m making the same income for the next 5-10 years I’ll be worried.

Beth
Beth
9 years ago
Reply to  Beth

Actually, maintaining this income would be great. I’ve known people who have had their salaries cut. Plus, if I have kids and can juggle that and my career, it will be a miracle 😉

Leah
Leah
9 years ago
Reply to  Pamela

I’m a teacher. And, heck, I’m not even licensed yet (working my way there to, as JD says, increase my income). For the past 5 years, I’ve taught college as a TA or taught at nature centers. My income has fluctuated from ~$10.5k at the lowest to $23.5k at the very highest (just one year for each of those, with the average more around $16k). No kids yet, but my goal is to be a licensed teacher making more by the time I have children. How do I increase my income? I find lots of little side things. I proctor… Read more »

Greg Miliates @ StartMyConsultingBusiness
Greg Miliates @ StartMyConsultingBusiness
9 years ago
Reply to  Leah

I used to work in traditionally low-paying field (social services), but switched to software/technology, after getting burnt out, and realizing it’d be extremely difficult to afford some of the things my wife and I wanted if we stayed in social services. But even so, if you’re in a traditionally low-paying field, don’t let that stop you from earning more. There are skills that you have that you can monetize–the key is providing value to the right market. It’s completely possible. I know teachers who do independent tutoring for a fairly high hourly rate. That’s one obvious example, but there are… Read more »

Dr. Jason Cabler (@DrCabler)
Dr. Jason Cabler (@DrCabler)
9 years ago

Einstein once said that “compounding is mankind’s greatest invention.” He’s absolutely right. But as you said, it’s only one tool in the tool box. Increasing your income without increasing your lifestyle so you can put more into savings will compound that compounding effect.

I teach in my Celebrating Financial Freedom course that compound also works against you when it comes to paying for things over time with credit. It will make your poorer every time so save up and use cash for everything!

Kevin
Kevin
9 years ago

“I teach in my Celebrating Financial Freedom course that compound also works against you when it comes to paying for things over time with credit.”

I hope you’re teaching them that this is only true in negative-amortization loan situations, where the payments are not even covering the interest on the loan, and the loan is actually getting bigger with every payment, right?

If your payments are actually decreasing the outstanding balance of the loan, then no compounding is taking place. It’s just regular interest. Virtually all loans work this way, including mortgages, car loans, furniture/appliance financing, etc.

Amanda
Amanda
9 years ago
Reply to  Kevin

I was just thinking recently how much I hate having a mortgage, that interest seems like a waste. However, when I look around at friends they’re paying the exact same amount as I am for housing. Only they’re renting. Their rent expense will likely go up around here over the next 10 years. Our payment stays the same. I need to think of the positives of home ownership.

Max From Liquid
Max From Liquid
9 years ago

I’d like to second your statement about the fact that compound interest is not a magic bullet. Yes, indeed, increased income would help. J.D. mentioned budgeting, and THAT is a tool that is often neglected. It is where you need to start, because that income, especially that increased income, may come to an end. A budget is not just to see where your money is going, but is the way to be LIQUID. Being liquid gives you the financial freedom you need.

Curby
Curby
9 years ago

Re: footnote, I was wondering when you’d tackle the issue of children. After all, you posted about the economics of pets and dating too, which are directly related, and also controversial.

When you love something or someone, you can easily and conveniently ignore the downsides of that relationship. It’s human nature to concentrate on the positive aspects of any situation that is not easily changed*, but of course there are still negative aspects. For significant life choices like having children, the trade-off could use some honest discussion.

* http://www.ted.com/talks/lang/eng/dan_gilbert_asks_why_are_we_happy.html

schmei
schmei
9 years ago

If you write about that other xkcd episode, you’ll likely be opening Pandora’s box. But as we’re expecting our first kid and looking at living on beans and rice for the next year while I support 3 people on one modest income, I had to laugh. It’s funny because it’s true…

Roberta
Roberta
9 years ago
Reply to  schmei

Yes, my hats off to you J.D. if you address the Pandora’s box of the other xkcd comic! As a parent, I also think it’s funny because it’s true. Our kids are worth it because we wanted a family, not a huge pile of money, so we “got our money’s worth” in effect.

Kaytee
Kaytee
9 years ago
Reply to  schmei

Wow, schmei, you could be me! We’re expecting our first and will also be transitioning to a beans & rice budget so my husband can stay home with the baby. Good luck to you!

schmei
schmei
9 years ago
Reply to  Kaytee

And best of luck to you! We’re clearly planning to get rich verry slowly, but I like to think the kids will be part of our “wealth”. 🙂

David
David
9 years ago

You should’ve mentioned the mouseover tooltip (often the best part of xkcd comics):

“But Einstein said it was the most powerful force in the universe, and I take all my investment advice from flippant remarks by theoretical physicists making small talk at parties.”

SB @ One Cent At A Time
SB @ One Cent At A Time
9 years ago

All I had to say are already said by comments above, really hard to think something new..still want to let you know I am read and agreed that power of compounding and regular contribution has no alternative to enhance retirement saving or any kind of saving for that matter. Wonderful short post JD, sometimes basic has to be re visited amidst ways of reducing costs on everything in life 🙂

imelda
imelda
9 years ago

“All I had to say are already said by comments above, really hard to think something new…”

Then don’t comment. You don’t HAVE to shill for your blog on every post, you know.

Kevin
Kevin
9 years ago
Reply to  imelda

THANK YOU.

I’m glad somebody said it.

Greg Miliates
Greg Miliates
9 years ago

Compound interest is indeed 1 tool in the toolbox. But like you said, increasing income can be a MUCH more powerful tool to gain financial independence. It’s like the metaphor that Dave Ramsey uses: having a bigger shovel (your income) to get yourself out of the financial hole you’ve dug. For me, increasing my income has also: –>completely changed my worldview –>made our family more economically secure –>allowed our family to have more flexibility I started my own business (a consulting business) in 2007, and have been able to grow it even during the shaky economy so that I’ve now… Read more »

Adam
Adam
9 years ago

My only beef with the compound interest argument that JD puts forth is that it relies heavily on the last few years to come up with the sensational numbers. Those last few years are precisely when you should NOT have your money risked in stocks in an attempt to earn 10%/yr, so the effect is to exaggerate results. For instance, let’s say that you invested aggressively for the first 20 years, and you earned a wonderful 10% every year. You finish 20 years with $100,000 in contributions and are sitting on $315,000 now. You are nearing retirement, so you shift… Read more »

El Nerdo
El Nerdo
9 years ago

I call bullshit on xkcd. Compound interest has powerful death magic when it’s 24% credit card debt. 2% is low mana and worthless.

Grumpy
Grumpy
9 years ago

I have heard the 10% growth numbers for the stock market a lot but I have not been that lucky. Looking at the S&P 500 for the past 10 years it has not got anywhere close to the 10 percent number. Sept 6 2001 it was at 1,106.40 and now it is at 1,154.76.

babysteps
babysteps
9 years ago
Reply to  Grumpy

Thoughts from a data addict on stock returns – long term, 7% is probably a better assumption about annual returns over a 10 year period. More specifics- Since 1928, the median annual return over a 10-year period on US equities has been 6.7% [using the Dow Jones Industrial Average (30 large cap stocks), looking at monthly closes on first trading day of month, nominal returns (ignores inflation), through august of 2011]. Same as above, but adjusting the figures for inflation (that is, “real” returns rather than “nominal”, applying CPI to the index value cumulatively), the median annual real return for… Read more »

babysteps
babysteps
9 years ago
Reply to  Grumpy

Thoughts from a data junky (links removed below for spam filter success) – Over the really long term, 6 or 7% is probably a better number for annual US equity returns over a 10-year horizon. Caveat: this excludes any contribution from dividends. From 1928 to today, looking at monthly DJ 30 index values, the median compound annual return over 10-year periods has been 6.7%. Looking at all 1-year periods (rather than the CAGR from all 10 year periods), the figure is 6.4% (lower in part because this includes the 8 more years of the most recent data). Same time period,… Read more »

babysteps
babysteps
9 years ago
Reply to  babysteps

err, “9 more years” not “8 more years”, fun with [not]editing 🙂

Grumpy
Grumpy
9 years ago
Reply to  babysteps

Thanks for the numbers. I think I am getting about 6% on most of my mutual funds. I am not rich like I thought I would be after 20 years of investing.

It is just when people give retirement numbers they usually use the 10% number and this 3 or 4 percent makes a huge difference. $58,000 at 10% interest in 30 years you have a million. The same $58,000 for 30 years at 7% is less than $500,000.

babysteps
babysteps
9 years ago
Reply to  babysteps

If you made your initial investment between 1977 and 1995, the 10yr CAGR was generally 10% or higher (same for 1942-1954).

More recently, not so much.

So the 10% number is somewhat reality-based, but is linked to unusually strong periods of equity returns. The 10% folks aren’t lying, but it isn’t the whole story of historical expectations, either.

Adam P
Adam P
9 years ago

Yes. I liken using 10% as your number to the story of Popeye and his spinach. For some reason, you think we’ll be less impressed by using 7% (Warren Buffet’s long term stock return number iirc), so you use 10% to make the compounding numbers look better than they really are (and also assume that as we near retirement, we’ll still be in all equities for our return instead of a near half-half mix of bonds which is more likely). Just like Popeye eating spinach, compounding is good, but as you want kids to eat it, you show Popeye gets… Read more »

shane
shane
9 years ago

i <3 xkcd. I was wondering if you were gonna get poked at to look at this strip. I was telling my husband although the comic is funny, if you had a lot more money, you'd get a lot more in return, like you were saying in the 401k example.

and the other comic strip… you can have children and money, it's not one or the other in every case.

Ginger
Ginger
9 years ago

Yes compound interest at 2% is not the helpful but compound interest at 4-10% is and it is not that hard to find those kinds of rates over 30 years.

Moneyperk
Moneyperk
9 years ago

There is obviously a very big difference between investing money and making more money. I’m no financial planner by any means, but I agree with you that it is essential to make more money. Invest that into short term markets, and use ROI to put into secure accounts such as a high-yeild savings account or IRA. To give you a great boost on compound. I realize there is more significant risk in short term markets, but I do believe you can reduce the risk. Plus, one winning stock can make you a fortune. So if you have enough side income… Read more »

Kent+@+The+Financial+Philosopher
[email protected]+The+Financial+Philosopher
9 years ago

Compound interest and increasing income are not anywhere near as powerful as contentment.

Human nature is such that more money equals more spending capacity.

“If thou wilt make a man happy, add not unto his riches but take away from his desires.” ~ Epicurus

Jen
Jen
9 years ago

This is a comment on the “possible” post. I agree with the comic, too. I stay at home with my three kids, and I often wistfully count the opportunity cost of anywhere between 30 and $50,000 a year that we are losing by me not working. I consider it an investment so when I am living in an RV, each kid will only have to have me four months of the year. I am glad I read this site, though, because it has changed my view from “be frugal” to “make more money,” and I am finding other ways to… Read more »

krantcents
krantcents
9 years ago

Either one is income, however increased income will trump compound interest especially in these low interest times.

david
david
9 years ago

Not one comment about the impact of inflation on those returns? Really?

The real question isn’t what you’ve earned… but what you can buy with your money. With a 2% earning, you wouldn’t even keep up with the rate of inflation. You’d be able to buy less with your $1200 than you could 10 years earlier.

Courtney
Courtney
9 years ago
Reply to  david

If your money is in a savings account, the rate is likely to fluctuate along with inflation over a 10-year period. Only a VERY risk adverse person would buy a 10-year CD at today’s low low rates.

retirebyforty
retirebyforty
9 years ago

Krantcents above is right on above. Increase income or compound interest are both extra income. If you save/invest enough, someday the compound interest will outpace income from an extra job. That day is probably far off for most regular people like us though.

Steve
Steve
9 years ago

Of course compound interest is not exciting when it’s only 2%, and when it’s only for 10 years. Duh. Interest rates are at historic lows right now and 10 years isn’t really that long. This isn’t even the first period in history where a safe savings account loses money to inflation over time.

When you use a more realistic (if risky and/or debatable) number like 7%, and a time frame measured in decades, then it really does start to seem like magic.

skeptic
skeptic
9 years ago

I think hearing the average return of the US stock market in the past is misleading. In my own amateur view, there is absolutely no way the economy is going to do as well in the next 50 years as it has done in the previous 80. we have created gigantic problems for ourselves (for instance, the lack of education in much of our workforce) while other countries have relatively flourished.

Courtney
Courtney
9 years ago
Reply to  skeptic

No one said you have to invest in the US stock market.

Adam
Adam
9 years ago
Reply to  Courtney

Right, so “diversify” into markets into which you likely have zero understanding.

I’m with Mark Cuban & Warren Buffet – invest in what you know. Diversifying will prove to be the bane of the early 21st century investor.

BD
BD
9 years ago

I wish I could have read this column back in 1990. In 401K presentations, the speaker would always present us with two scenarios: The wise person who saved at an early age, got up to a certain small amount, and quit saving, and the foolish person who started 10 years later, and was frantically trying to catch up. The wise person of course, had hundreds of thousands of dollars by the time the foolish person started saving due to the MAGIC OF COMPOUNDING. And of course, the speaker would then stress the need to start saving at an early age,… Read more »

GoBigRed
GoBigRed
9 years ago

As a fan of John Bogle (bogleheads.org) I must agree with your statement that “The single greatest factor in determining your retirement wealth isn’t your investment returns – it’s how much you contribute.”

I’d like to throw in that the 2nd greatest factor is the amount of fees a person is paying to invest. No-load index funds with extremely low rates are the way to go.

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