The unbridled power of compound interest

I’ve been investing in stocks on the TSX (Toronto Stock Exchange) and, in much less frequency and volume, the NYSE (New York Stock Exchange) for roughly 6 years now. In that time I’ve learned quite a bit. I’ve never taken a course or studied investing in any major capacity. My learning is the result of a balls out direct approach to investing. Pretty much just go and do it. In the beginning it was easy to get excited about the most minimal of changes in a stock. Especially during the day I bought/sold a stock. Pennies in changes would give me a rush, in the right direction, and a feeling like I swallowed rocks, in the wrong direction.

But that was then, and this is now. Over those 6 years I chose the route of dividend investing. Dividend investing revolves around the idea of filling your portfolio with most, if not all, stocks that provide a dividend. Dividends are cash returns provided by the company of the stock you purchased. Typical dividend returns are set either monthly, or quarterly and are based on a rate decided by the board of directors of the company.

Typically, what you hope and look for, is a stock that’s dividend will slowly rise over time. Banks are great for this, as they typically grow (or shrink) with inflation. When seeking a good rate of return on a “safe” dividend stock it is not impossible to find a relatively safe stock that provides a dividend in the 2-4% range. So, if you invested $1,000, each year you would be getting in the vicinity of $20 – $40 in cash dividends. Its a solid return, especially if tax protected in accounts such as a Canadian¬†TFSA (Tax Free Savings Account). Compared to what a bank will give you on a basic cash investment in a “savings” account its mind boggling good. A bank might give you 1%. And that’s a big maybe.

If you’re adverse to higher risk, you can invest in stocks that will fluctuate in value much more wildly, but will provide a higher return. Typically this is where I do my investing. With stocks like this you can find returns in the range of 4.5% – 10%. So, with that same $1,000 investment you’re now returning $45 – $100 per year. However, I can’t provide enough warnings about stocks that provide a dividend higher than 6%. Typically they are not as safe an investment, due to the stock value having the potential to drop dramatically.

The real power, though, in all this investing is not in your initial return, be it dividends or buying low and selling high. Instead its what you do with the money you’ve made. If you can reinvest it into the same, or similar, avenues of stock and average a return across your portfolio of 7%, then you can double your money in as little as 10 years. Sounds impossible, right? But its not, and that’s the power of compound interest. Its something that people are not taught in school, at least in regards to money and how you can achieve such things. A crime, really.

“Compound interest is the greatest mathematical discovery of all time.”
“Compound interest is the most powerful force in the universe.”
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. “

-Albert Einstein

EinstienIf you were alive when Albert Einstein was, and he happened to bump into you on the street and he sputtered any of the quotes above, you’d go and find out what he was talking about, wouldn’t you? Sadly, you probably wouldn’t. And even after I had heard of these quotes I didn’t. But then I started investing and it became pretty clear, pretty fast, that he knew exactly what he was talking about. Let’s bust out a graph to show you what I’m getting at here…

 

 

 

Account Value Interest Years Value Income Monthly Age Year
Estimates $1,000.00 7.00% 1 $1,070.00 $73.00 $6.08 25 2015
2 $1,144.90 $80.14 $6.68 26 2016
3 $1,225.04 $85.75 $7.15 27 2017
4 $1,310.80 $91.76 $7.65 28 2018
5 $1,402.55 $98.18 $8.18 29 2019
6 $1,500.73 $105.05 $8.75 30 2020
7 $1,605.78 $112.40 $9.37 31 2021
8 $1,718.19 $120.27 $10.02 32 2022
9 $1,838.46 $128.69 $10.72 33 2023
10 $1,967.15 $137.70 $11.48 34 2024
11 $2,104.85 $147.34 $12.28 35 2025

This graph shows how a $1,000 investment, at the age of 25, will double somewhere between the 10th and 11th year after investing. Its not black magic, its just math. Now think about what you could potentially invest each year? What if you could invest another $500, each year, on top of your initial investment? Or, what if you were lucky enough to have more to invest initially?

The basic idea here is that if all you did was invest one lump sum, it would only take 10 years to double if you were able to earn 7% interest on that investment each year. I don’t know about you, but that’s pretty damn amazing. The beauty is that every 10 years, anywhere in this scenario, whatever you started with, will be worth double. So, after your first 10 years, you had $2,000, in the next 10 years you’ll have $4,000, then $8,000, and so on.

If you’re reading this and you’re over 35, you might be thinking that you missed the boat. And to a certain level, that’s true, because its at the end of your investing with compound interest that you’ll make the most money. And if your end is sooner than if you started at 20, you’ll make potentially a whole 100% less, because you lost another 10 years of doubling your money.

But this post isn’t to make you fret. Get out there, and start looking at investments in a whole new light. And, think about your kids, if you have any. If you can invest $1,000, today, that can make 7%/year in a TFSA, and your kid is 5 years old, by the time they’re going to have $64,000 at age 65. That’s a 640% investment return! That’s assuming they did nothing with that investment and it kept making that level of interest, of course. My advice, don’t even tell them it exists.

I’ll be posting more about investing in the future, including what stocks I like from the TSX and NYSE, when the best time to invest can be and why market crashes can be your friend.

 

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