2 Things My Finance Teacher Said About Compound Interest That Changed Everything

2 things my finance teacher said that changed everything about compound interest

APPLE | SPOTIFY | AMAZON

Everything I needed to know from my college finance class came to me on the last day of school in the form of 2 very specific things my finance professor said.

All semester we learned how to read company financial reports, pick “good” investments, and calculate return on investment, but the truth is: none of that matters as much as the 2 things he told us on the last day of class.

I remember being 20 years old as I waited impatiently to be released for summer vacation when my finance teacher said something that changed my life.

He said: if you remember nothing else from this class, remember this.

That's when my ears perked up.

1) COMPOUND INTEREST IS THE 8TH WONDER OF THE WORLD

He said: “compound interest is the 8th wonder of the world.”

It’s a line he borrowed from a quote that’s been credited to Albert Einstein, and the entirety of the quote goes like this: “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t pays it.”

If you’re anything like me, you may have heard of compound interest, but you may not fully understand it. I was the same way, which is why I specifically remember this because, despite having spent an entire semester in a finance class, I felt like I didn’t fully understand it.

Essentially compound interest is interest generated on interest. And I realize that may not be super helpful, so let’s walk through a simple example to illustrate its importance.

Let’s say you invest $100 into the stock market. Historically, since its inception, the stock market has returned an average of 10%*, so let’s say performance is average, which means after a year, you’ll have $110. The way I calculated this is because 10% of $100 is $10, so if you add $10 to $100, you get $110.

Now, let’s say you leave your money in the market and, again, it performs at 10%. Remember, this year you started with $110 so, after the next year, you’ll have a total of $121. The way I calculated this is because 10% of $110 is $11, so if you add $11 to $110, you get $121.

The most important thing to notice here is, assuming nothing changed between the two years, in year 1, you received $10 of interest, whereas in year 2 you received $11 of interest. The reason you received more in year 2 is that you received interest on the interest you generated in year 1.

Another way to think about what you got back in year 2 is like this: You received 10% interest on your original $100, which is $10, and then you received 10% interest on the $10 of interest you generated in the first year, which is $1. So $10 of interest on your original money plus $1 of interest on last year’s interest equals $11 generated this year.

This is a very simple example, but it demonstrates how compound interest works. As time goes on and you generate more and more interest, the higher the new interest generated each year will be.

If you’re still a little confused, don’t worry. We’ll be spending most of our time today on item #2 and, after doing so, you’ll have a good understanding of compound interest and why it matters.

But before we move on, remember this quote… burn it into your memory: “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t pays it.”

2) INVEST NOW TO MAKE 2X MORE MONEY FOR ¼ THE COST

The second thing my finance teacher said was this: he said, “If you start investing today, at age 20, and stop investing at age 30 and never invest again, you’ll end up with more money than if you started investing at age 30 and invested until the day you died.”

What he meant was that, assuming normal market conditions, if you actively invested for 10 years starting now – and by actively invested he meant you’re regularly putting money into investments – and then stopped after 10 years, you’d end up with more money than if you waited 10 years, then actively invested for 50 years.

Let’s unpack that a bit because I realize how wild that sounds but I finally sat down and put numbers to this and it turns out – he’s right.

Let me walk you through 2 examples to demonstrate this. Please note, similar to what we did before, for both of these examples we’re assuming an average market performance of 10%.

Example 1: Let’s say you set up a monthly auto-deposit of $1,000 to your brokerage account that was used to buy investments in the stock market. You set up this auto deposit when you were 20, and you removed it at age 30. After removing it, you never put another dime into the stock market.

According to a compound interest calculator, and assuming you didn’t sell any investments, allowing the compound interest to work its magic, by age 80 you’d have contributed $120K to your investments, and the value of those investments would be over $30 million**. Wild, right?

Now let’s say, instead, you put off investing because you don’t understand it, or you’re scared of losing your money, or you aren’t sure how to begin – whatever the reason, you don’t start investing until age 30. But once you do, you set up a monthly auto-deposit of $1,000 to your brokerage account that’s used to buy investments in the stock market, and you keep your auto-deposit in place until you’re 80 years old.

According to the same compound interest calculator, and assuming you didn’t sell any investments, allowing the compound interest to work its magic, by age 80 you’d have contributed $600K to your investments, and the value of those investments would be just under $18 million**.

Let me reiterate. In the first example, you are contributing $120K of your own money, resulting in investments worth over $30 million. Starkly contrasted by the second example, where you are contributing $600K of your own money, resulting in investments worth just under $18 million.

According to this example, by waiting to invest, you’ve paid over 4x the cost for nearly half the value.

This example is profound, and it demonstrates exactly the point I believe my finance teacher was trying to make which is that time in the market is of utmost importance. Getting invested NOW and giving your money the time to generate compound interest as soon as humanly possible, to me, is one of the keys. That’s why it kills me to watch people kick the proverbial can of investing down the road always saying, “I’ll get around to it.”

To me, getting invested as quickly as possible given your financial circumstances should be one of your top 5 priorities and, if you’re already invested, then finding a way to contribute more money to those investments.

The secret here is time. And the time is now. The longer you wait, the more you could lose.

THE SECRET IS TIME & THE TIME IS NOW

I’d like to end this episode with a reading from the book The Psychology of Money by Morgan Housel where the author addresses legendary investor Warren Buffett’s success… as you’ll see, most of Buffett’s financial success can be tied back to the money he invested when he was young… and this is thanks to compound interest. So, let’s read this together and then I’ll close out.

“So when we’re studying why something got to become as powerful as it has — why an ice age formed, or [how] Warren Buffett [got] so rich — we often overlook the key drivers of success.

Let’s go back to Buffett: [When he was] 90, he ha[d] a net worth of more than $81 billion. A large portion of that, however, was accumulated after his 50th birthday. And $70 billion came after he qualified for Social Security benefits, in his mid-60s.

That said, those who attach all of Buffett’s success to investing acumen miss an important point. The real key to his success is that he’s been a phenomenal investor for three-quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him.

Buffett began seriously investing when he was 10 years old. By the time he was 30, he had a net worth of $1 million, or $9.3 million adjusted for inflation.

But what if he was a more normal person, spending his teens and 20s exploring the world and finding his passion — and, by age 30, his net worth was, say, $25,000? And let’s say he still went on to earn the extraordinary annual investment returns he’s been able to generate — 22% annually — but quit investing and retired at 60 to play golf and spend time with his grandchildren. What would a rough estimate of his net worth be today?

Not $81 billion. $11.9 million (99.9% less than his actual net worth).

Effectively all of Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. That’s how compounding works. Think of this another way: Buffett is the richest investor of all time. But he’s not actually the greatest — at least not when measured by average annual returns.

Jim Simons, founder of the hedge fund Renaissance Technologies, compounded money at 66% annually since 1988. No one comes close to this record. As we just saw, Buffett compounded at roughly 22% annually, a third as much. Simons’ net worth [at the time of this writing was] around $23 billion. He is 72% less rich than Buffett.

Why the difference, if Simons [was] such a better investor? Because Simons did not find his investment stride until he was 50 years old. He had less than half as many years to compound as Buffett. Had Simons earned his 66% annual returns for the 70-year span Buffett has built his wealth, he’d [have been] worth — please hold your breath — $63,900,781,780,748,160,000.”

THE BIG PICTURE

According to Morgan Housel, the author of The Psychology of Money, there’s an unmistakable driver of legendary investor Warren Buffett’s wealth that is technically accessible to everyone: time.

Buffett started investing at age 10… when will you begin?

If you’re feeling discouraged about not having started investing yet or not investing as much as you think you could or should or even just not investing in the best way you think you could learn how to – don’t! As the Chinese Proverb says: “The best time to plant a tree was 20 years ago. The second best time is now.”

You can’t go back in time. But you can make this a priority in your life right now. And learning how to invest with confidence isn’t something that will happen overnight. But you know what can? A single action. One step in the right direction.

And, before you know it, after daily actions toward this goal, you’ll build something for yourself that you may not have thought was ever possible.

But the important thing to remember is that you need to start taking action. And you need to do it now.

NEXT STEPS

If you’ve been wanting to learn how to invest with confidence but you’ve been feeling stuck on how to move forward, I have something that can help – it’s a 5 question quiz called “Are you ready to invest?”

And whether your results come back as, “Yes, you’re good to go!” or “No, you’re not quite there yet,” I provide 4 specific next steps that will help you take that action and get you moving in the right direction and toward your goal.

I hope you feel hopeful for what’s possible in the future and inspired to take action! This is something that’s within your control, and no one else can do it for you. It’s time to do the work to figure it out. I promise you, it’ll be worth it.