Albert Einstein was a pretty smart guy – I think we can all agree on that. The man who gave us the Special Theory of Relativity and the General Theory of Relativity famously said that the most powerful force in the universe was….?
Compound Interest!
Would you agree then, that this is something we should take a closer look at since it relates to investing and not atomic theory? :) Okay, if you are still reading I’ll assume you are, in fact, in agreement. Now it is time to either excite you or depress you based on your age!
First let’s define compound interest. Compound interest means that the interest you earn on an investment is based on both the principal (the amount you started with) AND the accumulated interest as well. So the interest you earn is always being calculated on an ever growing amount, meaning the interest you earn is always more than in the previous year. This is different than “simple interest” in which the interest you earn is only based on the principal amount at any given point down the road (i.e. the interest you earn is the same year in and year out). What’s the big deal? Well, I think it is best explained with an example…
Let’s suppose we have a fictitious GIC which earns 10% (compound interest). And let’s say we start with $1,000. Here is what the investment looks like over time:
Start of Year + Interest Earned = End of Year Amount
Year 1 $1,000 + $100 = $1,100
Year 2 $1,100 + $110 = $1,210
Year 3 $1,210 + $121 = $1,331
Year 4 $1,331 + $133 = $1,464
Year 5 $1,464 + $146 = $1,611
…
Year 10 $2,358 + $236 = $2,594
Year 20 $6,116 +$612 = $6,727
Year 30 $15,863 + $1,586 = $17,449
Year 40 $41,145 + $4,114 = $45,259
Year 50 $106,719 + $10,672 = $117,391
You can see that it started off pretty slowly, but at year 50 the interest alone was 10 times the original $1,000 investment. Now, what if you put $1,000 into this fictitious GIC EVERY YEAR? At year 50 you would have $1,280,299. Yup, $1.25 million.
Do you know how much $1000/year is on a monthly basis? $83.33 per month.
In fact here is something to think about. Let’s say we have two people, Johnny Saver and Joe Blow. Johnny Saver saves $1,000/year for 8 years and then stops saving his money. Joe Blow PROCRASTINATES like everyone else on the planet. He starts saving $1,000/year 8 years from now (when Johnny Saver has stopped adding money to his savings.)
In year 8, Johnny Saver starts the year with $11,436 saved and earns $1,144 in interest. Please note that $1,144 in interest (which is added back to his account) is more than the $1,000 that Joe Blow is starting to save to HIS account. Joe Blow comes to a very sad realization. He could save $1,000 per year for eternity and Johnny Saver would never again have to add a penny to his savings and Joe Blow will never have more money saved than Johnny Saver!
Let’s look at the results if this started at age 18 for both of them (and assume a retirement age of 65):
Johnny Saver starts saving $1,000/year at age 18 and stops saving at age 26 (total years of saving was 8, for a total investment of $8,000). At age 65 he would have just under $500,000 to his name.
Joe Blow starts saving $1,000/year at age 27 and doesn’t stop saving until age 65 (total years of saving was 38, for a total investment of $38,000). At age 65 he would have around $400,000 to his name.
So you can see that TIME IS ONE OF THE MOST IMPORTANT INGREDIENTS TO CREATING WEALTH!
Comparing this to CPP shows how unfair CPP is. If you work and contribute to CPP for 20 years, then are unable to work for the next 20 years, your CPP payout is drastically reduced because the government has spent the money rather than investing it.