There’s no sugarcoating it, 2020 has been a s***y year.
Covid-19 has come and has not yet gone. Yea we’ve got “sports” and no longer have to soak our groceries in isopropyl alcohol but we’ve still got masks, an election is still going on(?), and my hands are already dry from all the hand sanitizer and winter isn’t even over yet!
Now what?
We’re cooped up again – no going out – ordering doordash/grubhub, taking advantage of amazon fresh/instacart (or whatever your choice of grocery delivery is), and have already run through your list on Netflix (especially with Friends and The Office now gone and you know Stranger things will only last you one binge-induced weekend). So, now’s the perfect time to take that good hard (and probably overdue) look at your current and future financial situation. And where do you start? Let’s begin with the basics. Compound interest.
Compound interest is so simple, it is almost TOO simple.
In essence, over time more money begets more money. It is literally the concept behind “a penny saved is a penny earned”. The word “Compound” is derived from an Old French verb compoun which itself was derived from Latin componere or ‘put together. The english decided to throw a d on the end sometime during the 16th century, and the word compound was born. In its original form compound was often used in legal contexts to mean ‘make something bad worse’. In modern language compound generally means the same thing except without as much negative connotation.
Luckily compounding interest doesn’t mean “interest that gets worse”, but rather the opposite. Compounding interest is one of the foundational principles of modern finance and surrounds us, literally. If you’re reading this in a building right now (yes, even your own home!) – then whoever owns it more than likely has a loan on it, which is compounding at this very moment. That mortgage you’re paying off? Compounding interest.
The easiest way to think of compounding interest is to visualize growing a tree. Boughs grow from the trunk, twigs grow from the boughs, and buds spring from the twig. This process repeats itself until the tree is many multiple times bigger than it once was. After a few years the young sapling has grown into a full sized redwood.
Compounding interest works in the same fashion. Your money earns money, which in turn earns money. Over time your small sapling could grow into a mighty oak that can be cut down to build, or buy, a house (or pay for college, retirement, or that new Tesla you’ve been eyeing for the last few years).
How fast your tree grows is dependent on a few critical factors: Time, rate, and taxes.
| 1 time investment | |
| 0 | 1000 |
| 1 | 1050 |
| 2 | 1102.5 |
| 3 | 1157.625 |
| 15 | 2078.92818 |
| 30 | 4321.94238 |
- Time: Trees take many years to grow and bear fruit.
- Rate: Think of the earnings rate as the type of tree you choose to grow. If you want to grow a cactus, you picked something hardy and resilient but it only grows a few centimeters a year. If however you want to grow bamboo, yes it could shoot up fast and straight to the sky but it is skinny, slender, and can easily be cut down.
- Taxes: Taxes are the weeds; and it’s best to avoid them if you can. We’ll talk more about taxes (and how to avoid them or at least minimize them) in a future article..
Now, how can you take advantage of compounding interest?
Quite easily. Move your money into an account that can blossom. Storing money under your mattress or in a coffee is like storing seeds in a jar; neither are going to grow.
Odds are most of you reading this have some savings in a checking and/or savings account, and most of you probably are earning some form of interest/return. The issue is that the interest rate is so small that it would take you several hundred years to see any appreciable return. That’s not necessarily a bad thing.
To elaborate on our example earlier, let’s extrapolate, if you were to invest on average $85/month or $1000 per year and assume a meager 5% interest, over 30 years you could multiply your money by 2.5times. You’d turn $30,000 into ~$74k or if you’re lucky enough to be able to put twice that you’d turn $60,000 into ~$148k. This helps build that crucial nestegg…we’ll get more into this in our “sustainable retirement drawdowns” article where you take the 4% rule…maybe you’re really lucky and can invest $10,000 a year…here’s what it looks like…$750k
| Year | $1,000 a year | $2,000 a year |
| 0 | $1,000 | $2,000 |
| 1 | $2,100 | $4,200 |
| 2 | $3,255 | $6,510 |
| 3 | $4,467.75 | $8,935.5 |
| 15 | $24,736.42 | $49,472.84 |
| 30 | $74,082.73 | $148,165.47 |
We’ll pick it up more in a later post where we cover various types of investments but the key rule to your rate of return is risk = reward; in other words the higher the risk the higher the reward. With all this being said and with the beginning of a new (and hopefully better!) year, it may be time to reevaluate where you’re planting your money and you pick the tree that is best for you!