One simple calculation can change your life. According to legend, Albert Einstein may have called this deceptively simple formula the “greatest mathematical discovery of all time.” We call it your ticket to financial independence.
Welcome to the miracle of compound returns.
It’s about interest. Earning a slightly higher rate of interest on your money can make a huge difference to the amount of money you end up with in the long run.
This is how it works:
- You earn some interest
- Next year, your earn interest on that interest
- The year after, you earn interest on the interest on the interest
- And so on…
- You become financially secure
Rates Matter, A Lot
More than anything else, interest rates determine how quickly and how much your savings grow. The higher the rate at which you invest, the more – and the faster – your savings will grow, which is why you should make every effort to get the highest possible rate.
Since words cannot adequately describe the magical nature of compound returns, let’s try a few visuals.
How a single $12,000 investment grows
| Savings account (0.1%) | Bonds (5%) | Stock Market (9% *) | |
| Initial Investment | $12,000 | $12,000 | $12,000 |
| 5 years | $12,060 | $15,315 | $18,463 |
| 10 years | $12,121 | $19,547 | $28,408 |
| 15 years | $12,181 | $24,947 | $43,710 |
| 25 years | $12,304 | $40,636 | $103,477 |
| 30 years | $12,365 | $51,863 | $159,212 |
| 35 years | $12,427 | $66,192 | $244,968 |
| 40 years | $12,489 | $84,480 | $376,913 |
*Based on the stock market’s historical rate of return.
As you see, $12,000 can turn into nearly $400,000 over 40 years, thanks to the interest you earned on your interest over time.
Ok, but let’s be honest: $376,913 isn’t what it used to be in Hong Kong. That’s not even enough for a down payment on a flat today. But what if we invest $12,000 every year?
A more compelling table than the previous one
| Savings account (0.1%) | Bonds (5%) | World Stock Market (9% *) | |
| Initial Investment | $12,000 | $12,000 | $12,000 |
| 5 years | $72,240 | $84,938 | $96,743 |
| 10 years | $132,783 | $178,028 | $227,132 |
| 15 years | $193,628 | $296,837 | $427,751 |
| 25 years | $316,235 | $641,998 | $1,211,365 |
| 30 years | $378,000 | $888,993 | $1,942,115 |
| 35 years | $440,074 | $1,204,228 | $3,066,464 |
| 40 years | $502,459 | $1,606,557 | $4,796,415 |
*Based on the stock market’s historical rate of return.
This is where investing regularly can really help you build a tidy sum over time. By setting aside $1,000 every month (or $12,000 every year) you are effectively putting your money to work straightaway. You are unlikely to notice the money coming out of your bank account every month, but you could be pleasantly surprised at how even investing small amounts can mount up through compounding over the years.
The amazing story of the Mississippi washerwoman
Oseola McCarty was born in Mississippi, USA, in 1908. For nearly 75 years, she lived in the same simple house, washing other people’s clothes for a living and putting whatever money she could into savings accounts at banks.
In 1995, Oseola made headlines when she donated $150,000 to the University of Southern Mississippi to establish a scholarship fund. “I just figured the money would do [scholarship recipients] a lot more good than it would me,” she said. It soon came out that this washerwoman had managed to save nearly one quarter of a million dollars over her lifetime.
Time — a key part of the compounding equation — helped turn her small early investments into hundreds of thousands of dollars.
It could have been a happier ending
As remarkable as the Oseola McCarty story is, the ending could have been a blockbuster. After she died in 1999, one of her bankers wrote to us saying: “Time was able to turn even the modest returns of her early investments into hundreds of thousands of dollars. If we had been able to introduce her to equities earlier, she would have left millions instead of thousands.”
While the amount you save and how long you save for are important, they are only part of the equation.
This might cost you hundreds of thousands of dollars
Typically, the more risk you are willing to take on (say, by investing in shares rather than a standard bank savings account), the higher your potential return. But some people just don’t like risk; they are willing to settle for lower returns just to avoid it. They keep all their savings under their mattress, or look around for a fixed deposit savings account with the best deal. We think that’s a bad idea. You are actually losing money if the interest rate you get is lower than the inflation rate. (And in Hong Kong, that situation is always true). Here at The Motley Fool, we believe that the best place for your long-term savings is the stock market.
Through the course of our 13 Simple Steps to Financial Security, we will show you how you can save and invest your money well.