Compound interest – Have you ever wondered why some millionaires have so much money and yet you hardly see them work for it? Do you sometimes get concerned that you won’t have any money saved up for your child’s education or for your retirement? Do you want to get out of the rat race; of working a 9 to 5 job and become financially independent when you are in your 40s?
Compound Interest Can Make You a Millionaire
In this article, I will reveal a secret formula and strategy which the rich have used and passed down through their generations, and the funny this is, most people aren’t even aware of it, yet it’s so simple. But before I do that, let me tell you an old story of a king and one of his countrymen. There was once a very powerful king ruling over a vast territory, his kingdom was so large that some claimed that his kingdom stretched as far as the eyes could see and that it took men on horses months to cover one end of his kingdom to the other. His riches and wealth seemed to have no bounds. This King enjoyed playing games and after playing every kind of game that was available at that time, he challenged his countrymen to invent a game that would impress him.
After a few weeks had passed by, a man came to the King’s palace and requested the presence of the king to show him a newly invented game. This game was called chess and it was a strategy-based game. The king was so impressed by the new game that he said to the man, “Name your reward”. The man thought for a moment and then responded, “Oh Emperor, my wishes are simple. I only wish for this. If you place just one grain of rice for the first square of the chessboard and double it for every square, I will consider myself well rewarded.”
The King was reluctant at first as he wanted to give the man a much bigger reward for his invention perhaps in the form of gold but eventually agreed to give what the man had asked for. Upon the King’s order, his treasurer started to calculate the amount of rice that needed to be given to the inventor. The treasurer placed one grain of rice on the first square, two on the second square, four on the third square, and so on. By the time he reached the tenth square, he had to place 512 grains of rice.
On the twentieth square, the number swelled up to 524,288 grains of rice. Halfway through the chessboard, the number had reached 2,147,483,648 or approximately 2.15 billion.
When the treasurer reached the last square on the chessboard, he realized that the king owed around 9.2 quintillion grains of rice to the inventor. The figure was so huge that eventually the King, to honor his word, had to leave his throne and give it to this wise man.’
This story explains the power of compounding. It’s also sometimes called the ‘8th wonder of the world’. Never underestimate the power of compounding. The rich are very well aware of the magic of compounding and that’s why you will rarely find them burning their precious hours working a 9 to 5 job. Instead, they will let their money work for them by utilizing the power of compounding. If you haven’t already figured out how the rich make their money work for them, let me tell you how.
It’s simple! They make investments that compound in value over a longer period of time. To illustrate this point, let’s take the example of Jack, who is currently a 25-year-old man and has savings of $1,000.
He can realistically earn a yearly return yielding somewhere between 8% to 14% on his investments annually. The MSCI World Index has an average yearly return of 8.7%, so let us assume he invests his $1,000 savings through this index fund. This is how his investment of $1,000 will grow over time: When Jack turns 65 years old and is in his retirement, his $1,000 would have compounded to $21,725.
That is a huge amount considering Jack had only made a single one-time investment of $1,000. It represents more than a 2000% return or in other words; his investment has increased twenty-fold. Some of you might be thinking to yourself right now that 21 grand is a solid return, which it is, don’t get me wrong. But although $21,725 is a good amount of money to have at 65, especially when you only invested $1000, that money won’t last long and it will soon run out. It might afford him a luxurious vacation or two, but by no means does it permit him to quit his 9 to 5 grind.
So the question is; how can Jack or you use the magic of compounding to turn into a millionaire then? Let us now consider the example of Jill, who has done her undergraduate studies in finance from a well-reputed business school. She has learned about the power of compounding and how to harness it to achieve her goals and dreams. After her graduation, she lands a job that pays $4,000 in monthly salary. She makes sure she saves $1,000 per month and invests this through the same index fund that Jack did, earning a yearly return of 8.7%.
She is 22 years old right now and plans to make regular monthly investments until her retirement at the age of 65 years old. Still skeptical if she will become a millionaire? Let us see how her investment pans out assuming an 8.7% yearly rate of return. If she continues to stay true to her investment strategy, putting $1000 into an index fund, she will become a millionaire at the age of 47. Yes, you heard that correctly! Just by investing $1,000 every month, she will attain the status of a millionaire within 25 years! Since she first started investing. If she keeps at it, investing $1000, in another 18 years before she reaches her retirement age of 65, she would have accumulated another $4.68 million. Therefore, at the age of 65, Jill’s investments would be worth an astronomical value of $5.68 million.
Which is more than enough money to enjoy a happy retirement, if you ask me.
So in conclusion; If you are under 25, you have one of the biggest advantages when it comes to harnessing the true potential of the compounding effect – which is time. Time will be the greatest ally in your fight for financial freedom not just for you but for your future generations as well. Someone must get the ball rolling, and your future generations will respect you for being the one who does. Start saving regularly while you are young; this will give your investment portfolio the time it needs to really ripen the fruits. Let me give you an example of three investors who start investing at different stages in their lives, each of whom saved the same amount of money over a 10-year period.
So, Michael started saving $1,000 per month from the time he turned 25 until the time he was 35. At this age, he stopped making investments completely and left the savings in his account to accrue at a 7% return until he turns 65 years old. Jennifer did not start saving until she was 35 years old. She saved the same amount of $1,000 per month till she was 45 years old after which she left the balance in her account to accrue at 7% return until she turns 65 years old.
Sam never got around to investing until he turned 45. He started investing $1,000 till his 55th birthday after which he also left the balance to accrue at a 7% yearly rate until his 65th birthday. Over the 10-year period, all three were able to save the same amount of $120,000 and earned the same rate of return of 7% over it. However, because the total value of their investments was significantly different when they reached the age of 65.
Michael had accumulated a whopping $1,444,969, whereas Jennifer was able to muster a net value of $ 734,549. Poor Sam lagged far behind with a balance of just $373,407. So, what lessons do we learn from the strategy followed by Michael? Thanks to the power of compounding, time is the most important variable a young investor has on his or her side.
Start investing early by contributing a small portion of your income into your savings account or whichever other investment vehicles you have opted for. Continue doing this consistently for at least 10 years and you will realize that after the 10-year period you might not even need to save at all. At the age of 35, while all your other friends are struggling to make their ends meet, you will be well settled enjoying a handsome return on your portfolio.