Albert Einstein reportedly called compound interest the greatest mathematical discovery of all time. On its surface, compounding is innocuous — even boring. “So what if my money earns 5.40% in a high-yield savings account?” you might ask. “What does it matter if it averages 10% annual growth in a mutual fund? Why is it so important that I start investing now.”
In the short-term, it doesn't make a huge difference, but on the slow, sure path to wealth, we take the long view. Short-term results are not as important as what will happen over the course of twenty or thirty years.
In today's episode of “Saving and Investing”, Michael Fischer examines the power of compounding. He uses several tables, but they don't display well on YouTube, so I've taken the liberty of scanning them from his book. You'll find them in the notes below the video. (This is by far the longest video in the series, but as Michael says, it may be the most important.)
The power of compounding (10:29)
Here are the exhibits Michael uses. (Warning: these links open new windows.)
- exhibit A: $1000 compounding at 5% (years 1-10)
- exhibit B: $1000 compounding at 5% (years 11-20)
- exhibit C: $1000 compounding at 5% (ski-slope graph)
- exhibit D: Abby vs. Zak (the power of starting early) — this is important
- exhibit E: difference between 1% compounding and 3% compounding
- exhibit F: $600/month compounding at 7% for 30 years
- exhibit G: 16% interest doubles debt over five years
The following supplementary information may be of interest to you:
- Last spring I wrote about how compound returns favor the young. Vincent, a GRS reader, contributed a simple spreadsheet with which you can explore compounding.
- At one point Michael says: “By putting it in a CD or another instrument that is equally riskless…” High-return “riskless” investments include certificates of deposit (CDs) and money market accounts.
- “We tend to adjust our spending patterns according to what we make,” Michael says at one point. This is lifestyle inflation. Remember how you used to be able to survive on half of what you earn today? How was that possible? The problem is your lifestyle has expanded to match your income.
Finally, here is Michael's explanation of why this subject — saving and investing — ought to be studied:
Why this subject is so important! (1:13)
To summarize: if you're financially literate, you're better able to make decisions about money, whether on your own, or when working with a financial adviser.