Compound Interest

tracking investments in the stock market

Pop quiz: What is the most powerful force in the universe? Is it:

  1. gravity
  2. electromagnetism
  3. the strong nuclear force
  4. a toddler resisting bedtime

According to various stories circulating online, Albert Einstein once offered a surprising answer to this question. What is the mysterious force he supposedly described as a “miracle,” the “8th wonder of the world,” and “the most powerful force in the universe?”  

Compound Interest.

If you’re familiar with the term, you might wonder why anyone would refer to it as the most powerful force in the universe. In this article, we’ll explore the concept of compound interest and its financial implications.

What is compound interest?

Your grade school curriculum probably included lessons about the differences between “simple” and “compound” interest. If that seems like a lifetime ago, don’t worry. You probably learned everything you need to know about the power of compound interest from an unlikely teacher: cartoons. If you’ve ever seen a cartoon character form a snowball at the top of a hill, you probably know what happens next. Compound interest is the financial equivalent of an animated snowball, growing and gaining momentum as it rolls downhill.

How does it work?

Thanks to the “miracle” of compound interest, an investment’s growth builds upon itself over time. For example, an initial investment of $100 that grows 10% in its first year provides a $10 return. In the second year, a 10% gain on the original $100 and the $10 of first-year earnings corresponds to a total gain of $11. That extra $1 of earnings in year-two doesn’t sound like much at first, but the snowball effect continues to accelerate. After 10 years of 10% growth, $100 becomes $259. After 20 years at the same rate, $100 grows to $672. Within 25 years, the “extra” compounded earnings each year would exceed the original $100 investment.  

Of course, it’s not enough to realize that the snowball effect CAN occur, or even to recognize HOW it occurs. To harness the snowball effect, you have to understand how your decisions affect the size and speed of the snowball.

As you’ll see below, the cumulative benefit of compound interest depends on three key variables: how much you invest, how much you earn, and how much time it has to grow.

Asset Class Compound Annual Return Invest $1 in 1980 and 40 Years Later it Becomes: Years Needed To Double Your Money
Large US Cap Research Index 12.16% $110.37 6.0
Small US Cap Research Index 12.02% $104.95 6.1
Long-Term Corporate Bonds 9.48% $40.94 7.6
Long-Term Government Bonds 9.34% $38.90 7.7
US Consumer Price Index 3.03% $3.40 23.2

Source: DFA Returns Data (1/1/1980-12/31/2020)

Historical data provided by investment firm DFA offers insight into the cumulative impact of compound earnings. This chart reports the average returns of several common investment categories dating back to 1980. These figures reflect the average annual rate of return, the cumulative growth of a single dollar, and the amount of time it would take to double your original investment. The returns listed represent an average growth rate, compounded over time, accounting for all interest and dividends received and reinvested into more shares or bonds. The returns for each category might have been much higher or much lower for any given year. Still, the long-term averages for each category have been remarkably consistent over time.

Believe it or not, the average returns depicted above include ALL of the challenging economic circumstances investors have faced over the last 41 years. That includes the tech bubble, 9/11, the financial crisis, and the coronavirus pandemic. 

You’ll notice that the different growth rates led to wildly different results. From 1980 through the end of 2020, stocks of large US companies have averaged a 12.16% annual compounded return through capital gains (rising share prices) and dividends (quarterly cash payments, which were reinvested in more shares). In the same period, longer-term corporate bonds returned 9.48% annually.

The long-term returns were even higher for small company stocks. Their 11.87% average return might not sound like much more than the 10.16% for larger companies, but consider this: the modest outperformance of small-company stocks delivered a portfolio more than 4 times the size of its large-company counterparts. Because of compounding, the slightly higher annual return led to a much higher cumulative return.

Why are these results important?

The examples above demonstrate the power of compound earnings over time. The figures also illustrate the tradeoff between risk and reward for different investment opportunities. It’s tempting to think that the “cost” of prioritizing safety is no more than the four or five percent difference in historical averages between stocks and bonds, but that drastically underestimates the power of compound interest. A difference of four or five percent on average, over many years, is enormous.

A long-term perspective is not simply a matter of courage or confidence in the face of uncertainty. Disciplined investing isn’t the denial of risk, but the acceptance of it. There will be good years and bad years for every type of investment. By accepting a longer time-horizon, you create more opportunities for good and bad returns to average out. A longer time-horizon also offers more opportunities for compounding.

It is impossible to predict future returns. It always will be. Fortunately, you don’t have to predict those returns to benefit from them. You can harness the power of compound interest by starting as early as possible, saving as much as possible, and staying invested for as long as possible.

Just remember, you’ll have the most powerful force in the universe behind you. 

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