I find compound interest pretty amazing. It’s believed Einstein once said compound interest “is the most powerful force in the universe”. Did you wonder why investors are looking to squeeze every little extra quarter percent increase? Professional investors will spend countless hours and money to improve investment returns only slightly. Meaning they will spend money (on investment analysts, economic advisers, research reports, etc.) to make additional money? The additional returns could only be a quarter of a percentage point, if that. Why is that? I thought about this the other day and ran the numbers. I was completely blown away by this. You don’t have to be a genius to take advantage of this.
It’s amazing how much money you lose if you just make 1% less in returns, over the course of, say, 30 years. It’s only 1% we are talking about, and it can’t be that big of a difference.. can it? To simplify things, let’s use a retirement account as an example. Depending what numbers you look at, returns on the US stock market have been around 8-9%. Let’s assume all money is invested in the U.S. stock market, and not get into proper asset allocation. For our hypothetical example, let’s use an 8% return on the money invested. It’s invested in a 401k/IRA, so you don’t have to worry about taxes. While investing for 30 years, $10,000 is added annually. Here is the break down every 5 years, and a comparison to a 7% return.
|Years||8% Return||7% Return||Difference||% Difference|
Over the course of 30 years, your return would be $1,132,832.11. OK, let’s assume you didn’t make some wise decisions, and over the course of 30 years your return was only 7% instead. Your total return has been reduced to only $944,607.86. A significant difference of $188,224.25 in the net result. So a 1% return difference in your investing can be dramatic. Over 30 years you have 16% less in your pocket. Notice after only 5 years the difference can become dramatic. Now you know why investors scour constantly for the highest returns possible. Obviously notice as time marches on the difference increases dramatically. That’s the “magic” of compound interest.
I think two things can be said about the revealing results. For investing and saving – start early, do it consistently, and do as much as possible without cramping your lifestyle. Secondly, what most people don’t realize is how much expenses can eat at your returns. It’s not uncommon for investment fees to be higher than 1%. Over the long haul, it’s common for active investments to trail an index because of their management fees. The active investment becomes more or less the index and mirrors its results. The net effect is the expenses they charge equal the amount they drag against the index. This is one of the valid reasons not to use active management in your portfolio.
The sad part is most people don’t consider expenses as part of their return. For the average index based mutual fund the expense fee is 0.50 – 1.00% annually. On actively managed funds, the rate is much higher. Keep this in mind when choosing your investments, and choose your investments wisely. Otherwise, over the course of 30 years the difference in return can be dramatic.