Investment time & the magic of compound interest

Should I invest now? -series 🤔 1/3

The “Should I invest now?” -series looks into three things that many first time investors find puzzling:

1. Time: How long should you invest & the magic of compound interest

2. Timing: When to board the financial markets rollercoaster

3. Barriers: Dealing with doubts, finance nightmares and those clingy savings accounts

Let’s get going, shall we? As we’re going to learn (spoiler alert), we shouldn’t waste time and start investing as soon as possible.


👉 Time


 

Find out why your dog's birthday is a perfectly fine day to start investing. Given your dog's birthday is today.

 

When talking about stock markets, many (also me) immediately imagine scenes from movies or the news, where people jump up and down screaming “buy” and “sell”. In specific, I have Cameron Diaz in What happens in Las Vegas stuck in my head. Anyway, this kind of investing sounds stressful and hectic - and absolutely not like something we are talking about today.

We will look at the stock market from a long-term investing point of view. Because as they (all the experts on the internet say):


Stock markets favor the ones that are in for the long run.


Today we will closely examine what it means to put money into stock markets for the long-term and what impact starting early really has.

As we are going to have a closer look at the global market growth in our next article, here we will simply calculate our examples with an average of 6% market growth per year.

The magic of compound interest

There is one financial concept that sounds extremely boring but is like a little magic trick that hides in plain sight: Compound interest.

Compound interest and its magic come into play and have the biggest impact on growing your investments if you invest as early and for as long as possible.

This basically boils down to the fact that if you hold your money long enough on an investment account (given the right strategy and plan) you will see your money grow year by year due to little returns, without you yourself basically doing that much yourself.


Compound interest (or compounding interest) is interest calculated on the initial principal and which also includes all of the accumulated interest of previous periods of a deposit or loan.
— Investopedia, 2018


Translated to “human”: With long-term investing, we might calculate with an average of around 6% growth rate per year. And this then means that after 1 year, you have earned 6% of the initial sum you invested. The following year you will get interested on this higher amount (initial sum + 6%). Interest is always based on the previous year’s amount and not on the initial (smaller) amount.


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Now that we realised how compound interest works, we might want to look at the impact time has on this compounding magic.

Compound interest over time

Nora would like to start saving for her retirement. She is 25 years old, has around 40 years until she retires. So she starts to invest her money on a monthly basis - 200 CHF per month.

Let’s see how much money she’ll have when she’s 65 years old.

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Nora saved up 98’600 CHF on her own, but what she got when she’s retiring are 303’917 CHF! Three times as much. Well, hello you compound interest 😏

Along comes Harold - he decides to start investing with 35 years, getting a bit stressed about his retirement plans. Let’s say he also starts saving 200 CHF a month.

Even though Nora in this example started 10 years earlier AND stopped investing when she was 35 years old, Harold’s investments did not catch up with Nora’s. Due to *drumroll* the magic of compound interest!

So even though Nora only invested 24’000 CHF in total, she gained more until her retirement than Harold, who invested 60’000 CHF in total. Compound interest still kept working in the background, growing her wealth over time.

What we can see very clearly in this example is that starting to invest EARLIER pays off way more than continuous investing taken up later in life.

Extra tip

…for when you’re doubtful after a short period of time

After 5 years, the compound interest doesn’t look like too much - am I right? It kind of feels like, nothing is happening, which is why I am calling compound interest this “magical thing hiding in plain sight”. It’s there, and working, but you don’t see it for a couple of years.

After 10 or 20 years, the relation to what you had in the beginning and the compounded earnings is staggering.

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Let’s talk about risk, baby

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After glorifying compound interest, we should still talk about risk. By choosing carefully what you want to invest in you may reduce risk of losing money. Our calculation examples are based on an average of 6% market return based on globally spread investments.

Make sure you are choosing a mix of of investments that fits your life, the risk you want to take and do not despair. We are talking about an average of 6% return as some years it might be 10%, but some years it might also be 1%.

Long-term thinking keeps you steady and on the low-risk side.