Investment time & the magic of compound interest

Should I invest now? - series 🤔

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

⏳ Time: Investment time & the magic of compound interest

🎂 Timing: When to board the financial market’s rollercoaster

👀 Barriers: Doubts, finance nightmares and clingy savings accounts


Part 1: Time


 

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

 
 

When talking about stock markets, many (me including) immediately imagine scenes from movies or the news, where suit-and-tie people agitatedly jump up and down, point at screens and wave their hands, screaming “BUY!” and “SELL!”. For some reason, I have Cameron Diaz in “What happens in Las Vegas” stuck in my head.

Anyway, this kind of investing is stressful and hectic. And this is really not the kind of investing we are talking about today.

Mainly, we are looking at the stock market from a long-term perspective, because as they (all the experts on the internet) say: Stock markets favour those who invest for the long run. What is long-term though? What does it mean to let your investments “brew” for five, ten or even thirty years? And what impact do an early start and compound interest have on all of this?

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. 🧐

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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 has the biggest impact on growing your money, when you invest as early and for as long as possible. We’re talking about several years – preferably 10, 15 or even more.

The magic basically boils down to one simple idea. That if you hold your money long enough on an investment account (given the right strategy and good care), little by little your returns start to compile interest, without much work from you.

 

How does it work?

 
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
 

Yep, okay. Right. Let’s translated that to “human” 😅 And this works best with an example.

 
 

For the sake of a simple demo, all examples below have a fictive av. 6% annual return, the compound interest that's paid annually – at the end of the year, and no fees.

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Today

Imagine your first investment is 10’000 CHF. Or, in fancier financial terms: "the initial principal".

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1 year

With our fictive average 6 % market growth, you earn 600 CHF in the first year. At the end of the first year, you will then have 10’600 CHF in total.

That’s easy. What’s next?

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2 years

In year two, the same fictive 6% return gets you 11’200 CHF. True?

👩🏻‍🔬 Almost. Here’s where things get interesting. Because of the compound “interest on interest” you got an extra 36 CHF! These come from getting interest on the amount you earn after the first year: 6% on 10’600 CHF = 636 CHF.

After year two you know already have 11’236 CHF.

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10 years

Ten years fly by. With the same example return going strong, you may expect to have 16’000 CHF, correct?

Ah, but now we know about the compound effect! The interest-on-interest keeps on adding up, and voilá, now you have 1’908 CHF more.

In 10 years, you will then have 17’908 CHF instead of 16’000. Magic! 🔮

 
 

Compound interest over time

Now, that we know the basic idea behind how compound interest works, let’s take a closer look at what kind of impact time has on all of this compounding magic. Our imaginary friends Nora and Harold will help us through it.

 
 
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Investing for 40 years

Nora starts saving for her retirement. Well, as she calls it – “saving up for the future”, since who thinks about retirement in their 20’s? Rock stars? True, but that’s beside the point.


Back to Nora:

🎂 Age 25 years old

Retirement in 40 years, at 65

🎢 Saving 200 CHF / month


In a friction-free example world, forty years of dedicated, steady savings would bring Nora 96’000 CHF. Not bad, but what about that compound interest?

Let’s keep the similar set up as in the previous example.

  • A fictive average return of 6% in a year

  • No fees or costs

  • One yearly compound interest payment

  • … calculated on that year's average sum

The last point means that the interest is based on how much money Nora has on her account at the end of the year – and that number divided by 12 months.

👉 Note that this is just an example. The real world comes with all sorts of fees, risks and ups and downs.
 
 

Here’s Nora’s savings illustrated in a classical financial chart. You might have seen these type of graphs around. I kind of like looking at graphs (paha!), but this one really got me thinking. Could it really be real? 🤓

Let’s unwrap the graph and the math. After four decades of uninterrupted savings, our devoted saver Nora gets a staggering ~289’600 CHF, from the interest returns alone! That is three times as much she would have saved with simple deposits on your bank account. Well, hello you, compound interest. 😏

That’s nearly 382’600 CHF in total. 🔮👩🏻‍🔬

 
 
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Investing for 30 years

Along comes another imaginary friend, Harold. Thanks to all sorts of targeted, feel-good-intended saving’s plan ads – mostly featuring handsome senior couples laughing amid picturesque scenery – Harold is getting a constant reminder of the inevitable passage of time. 🙂 Lovely.

Until one day, after years of irregular gigs, Harold lands a stable contract and with smiling grey-haired saving’s plan ad couple in the back of his head, he decides to get his investments in order.


About Harold

🎂 Age 35 years old

Retirement in 30 years, at 65

🎢 Saving 200 CHF / month


The previous graph already gave a hint on what happens if the same conditions apply.

After 30 years of stable monthly saving, Harold saves up 72’000 CHF. The interest-on-interest returns add around 123,400 CHF more to the picture. That’s close to 195’400 CHF in total. Not bad. 🔮👩🏻‍🔬

 
 

Earlier vs. later?

 
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Although both, Nora’s and Harold’s, stable monthly investments paid off, the difference that ten years made is pretty mind-blowing. Nora’s approximate 400’000 CHF earnings are nearly double those of Harold’s.

And this is where it gets mind-boggling.

This part still makes me raise my eyebrows and tilt my head a bit while I study the graph. Huh? This is where compound interest really hits the home run.

🤓 Imagine that after ten years, Nora would have stopped saving monthly. How would that compare to Harold’s non-stop investing? Surely Harold’s investments would catch up with Nora’s then?

 
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🧐 Oddly enough, even though Nora stopped investing more money when she was 35 years old - at Harold’s age of starting to invest - his investments did not catch up.

Nora invested 24’000 CHF in total, Harold invested 60’000 CHF. Add time into the equation (40 years in this case!) and this is what you get.

Extra tip for when you’re doubtful after a short period of time:

The trick lies in “sticking with it”. After five 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 ten or twenty years, the relation to what you had in the beginning and the compounded earnings is staggering.

 

Takeaway

All of this might sound a bit discouraging to everyone in their post-20’s. There are all sorts of reasons why many of us haven’t had their financial plans all figured out fresh out of college. Irregular jobs, family situation, being busy with life. Not to mention that most investing services look and feel intimidating.

If that is the case, think of a good ol’ saying “it’s all relative”. Yes, an early start is excellent, but starting now still is better than never.

👉 Hopefully, your biggest takeaway from this post is a realisation that starting as soon as you can makes sense. ■

 

 

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