The Magic of Compound Interest

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This week, lets start with a quiz: How much money would you have today, if you had invested $10,000 in an S&P 500 Index Fund, in 1980?  With no additional deposits. That’s right one $10,000 deposit and no more!
A.  $380,000
B.  $276,000
C.  $433,000
D.  760,000

I will show you the correct answer below and how much you could potentially earn if you did the same thing today.

First, lets talk about compound Interest.  Although, I did not realize it at the time when I was 10, (I should have taken notes) my favorite aunt taught me the valuable lesson of compound interest.  I was spending the night with my aunt and uncle and as a nosy child when I opened the nightstand drawers I found a bank savings book.  You may not know what a savings book is, but decades ago when you opened a savings account the bank gave you a book the size of a passport. Every time you went to the bank to make a deposit, they would type in the amount of your deposit, any interest earned since the previous visit and show you your balance.  I know that thought is barbaric to some of you, but I very much enjoyed adding to my savings account and seeing the numbers climb. It was my way of keeping score!  I remember, glancing at the door, to make sure all was clear and sliding her savings book out of the drawer. Now a good child would have never touched that savings book!  I never said I was a good child, so of course I opened it!  I was amazed by the amount. The funny thing, I do not remember the amount, just it was as our current President would say- HUGE!  So many deposits, page after page and this one final HUGE balance number.  But what really amazed me was the interest.  The book listed numerous deposits and it also listed the interest earned.  Big dollar amounts were being deposited as interest! To me that was free money!  And while I did not know the term at the time, this was my first peak at the power of compounding.

Compounding refers to generating earnings from previous earnings. Compound interest is almost like magic. It makes dollars multiply before your eyes.  Let’s say you start with $1,000 in the bank. If the interest rate is 4%, (not even possible today, at a bank) you’ll have $40 more in the account at the end of the year. That’s simple interest. But the next year, you earn interest not just on the original $1,000, but also on the $40 in interest you’ve already earned.  In other words, your interest earns interest. That’s compound interest-good magic.  Interest is often compounded monthly, quarterly, semiannually or annually. With continuous compounding, any interest earned immediately begins earning interest on itself. Albert Einstein allegedly called compound interest “the greatest mathematical discovery of all time.”

Here’s a look at what would have happened if you had put money into an S&P 500 index fund in 1980 (38 years ago) and had simply reinvested your dividends along the way. What is an S&P 500 ETF Index fund? {Future Blog Topic}. An S&P 500 index fund is an investment vehicle, that invests in the 500 stocks that comprise the S&P 500 index.  This is an extremely cheap way to invest. S&P 500 ETFS can be found with expense ratios as low as 0.03% versus some Hedge Funds, with expenses as high as 2+%.

Investing in an S&P 500 Index ETF, happens to be mine and Warren Buffett’s favorite investment tool, for everyday Americans. In fact, Warren Buffett, said he wants his wife’s money invested in such a fund after he’s gone. This might seem a bit surprising, as Buffett is a master in picking winning stocks. But, he believes an investment in an S&P 500 index fund is a bet on American business, which has historically been a very good bet. Over the long run, the S&P 500 has generated total returns averaging 10% annualized.  And since S&P 500 index funds generally have minimal fees, you get to keep the vast majority of the returns.

QUIZ ANSWER
So, how much would $10,000 invested in 1980 be worth today?  Since January 1, 1980, the S&P 500 index has generated a total return of approximately 7,670% as of this writing. This translates to a 12.1% annualized rate of return. Assuming an expense ratio of 0.1% on your index fund, this means that a $10,000 investment would have turned into just over $760,000 as of Feb. 1, 2018. ANSWER = D

My aunt and uncle mastered two key factors, in building their wealth.  First, they strongly believed in savings.  In fact, they typically lived off one salary and saved one salary.  Second, the power of compounding.  In addition, to savings accounts my Aunt placed large sums in Certificates of Deposits (CDs), where you can lock the interest rates for one to several years.  My uncle would then utilize this cash to buy rental properties.  Ultimately accumulating over 30 Rental properties, on their journey to wealth accumulation.  Both my aunt and uncle were dedicated North Carolina, public school teachers.

How About Your Returns?
The past few years, the S&P 500 has returned an average of 8% versus the previous 12.1%. If you invested $10,000 in an S&P 500 ETF today, February 12, 2018, assuming 8% annual compounding, 38 years later, February 12, 2056, you would have ~$207,000. Much lower amount than above, because of a lower expected annual return. This indicates the importance of the annual return/performance. But what if, assuming 8% return each year you invest an additional $5,500/year (maximum amount today for an IRA). At the end of 38 years, you could have ~$1,363,283.

How much can you afford to invest today? Can you afford, to NOT invest for your tomorrow?

{A free app, I use for above calculations: Ez Calculations}

Powers Investments Management, LLC

This blog will provide, information and simple strategies, that will assist you to achieve YOUR financial objectives and long term targets. For over 30 years, I solved multi-million dollar problems, for Fortune 10-250, companies. My formal education includes: Business, Finance and Chemical Engineering {Problem Solving} at: Harvard, Rutgers and North Carolina State. And an additional 30+ years, managing my family’s investment decisions. I currently manage/advise people with net-worths ranging from the tens of thousands to several million dollars.

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