Investing Made Simple - Part II: Investing and the Power of Compound Interest

As promised in an earlier post, I am going to write a set of articles on the subject of investing aimed at the novice. To start things off, I am going to start with some of the basics of investing.

You probably know what investing is, but I will try to define it anyway. At its essense, investing is the act of taking your money and commiting it to some enterprise in the hopes of making even more money. Basically, you are telling your money to go out and "get a job", in a manner of speaking. This is inherently a risky activity. Sometimes, investing works and you will end up with more money than you started out with. However, there are times when investing doesn't work and you end up with less money than you started out with. Obviously, you would rather invest in some enterprise where you end up with more money.

There are an infinite number of different "enterprises" that you can invest in. Here are some examples:

• You can loan your money to a bank (by depositing it in a savings account) in return for the bank paying you "interest" in return for letting them use your money.

• You can loan your money to the U.S. Government (by buying a savings bond) in return for the government paying you "interest".

• You can buy part-ownership in a company (by buying stock in the company) in the hopes of sharing in the profits of the company.

• You can buy a house in the hopes of being able to sell the house for a higher price in the future.

Again, the main theme here is that you are setting aside some of your extra money in some way so that, hopefully, you will earn even more money than you started out with. The amount of money that you initially invest is often referred to as the principal. If you invest $100 in a particular stock, then your principal is $100.

Investors measure the performance of their investments by quoting a statistic called the rate of return. This is the amount of money that the investment has earned, as a percentage of the principal. Let's say that the stock that you bought for $100 earns you $10 in profit. Then your rate of return for this investment is 10%, since $10 is 10% of $100.

Usually investors look at the rate of return per year. This is referred to as the annual rate of return or the annual effective yield. What this means is that, over the course of a one year period, the investment is earning a rate of return of X%.

An annual rate of return of 10% may not seem like a lot at first. On first glance, you are only getting $10 for every $100 you invest. If you are an instant gratification type of person, this might not seem like much of return for your troubles. You want to get rich quick. However, there is a powerful concept in investing known as compound interest, which will get you rich if you show a little bit of patience. If you can only learn one thing about investing, then this is the one thing that you need to understand.

Compound interest is a very simple concept. What it means is that you earn a return on your past returns. For instance, let's say that after a year, your $100 stock has earned $10. Now you have $110. Let's also say that your stock earns another 10% in year 2. That isn't just 10% of your original $100 investment. That's 10% of your $110. At the end of year 2, you will have earned $11, so your total balance is $121.

So what, you say. $11 in year two isn't much more than the $10 that I earned in year 1. However, as the years go by, you are earning 10% on a ever growing pile of money. After 10 years, you will have $259.37. After 20 years, you will have $672.75. After 30 years, you will have $1744.94. As you can see, the rate at which your money is growing is accelerating! In the first 10 years, you made $159.37. In the next 10 years, you made $413.38. In the final 10 years, you made $1072.19. Now in year 31, your money is going to row $174.49, which is almost 2 times your initial investment of $100 - all in one year!

You can see how powerful compound interest can be, if you just can be a little patient.

The practical application of this is when you have to invest for some long term goal, like retirement or a child's college education. The amounts of money that you need for those things seems so large and unattainable that it is hard to motivate oneself to start saving for them. However, if you remember that even a little money saved now can turn into big money 20 or 30 years down the road, those goals don't seem quite so insurmountable.

The important thing to remember is that as time goes on, your earnings will accelerate because of the power of compound interest. Therefore, it is crucial to start investing as early as possible. When you are 25 years old, retirement seems so far away, so you may not be motivated to save for it. However, if you wait until you are 35 to start saving for retirement, you will have lost a lot of money, since now your investments have 10 less years to grow. 10 years may not seem like a lot. However, with compound interest, you can get a lot of earning acceleration in that extra decade.

Here is some motivation for you. You say that you don't have money to set aside for retirement. However, if you really try, you can probably squeeze $100 a month out of your budget to invest. It isn't hard to do. You may have to give up your daily latte, and you might have to pack a lunch instead of dining out every day, but those aren't big sacrifices to make once you read what I am about to tell you.

Let's say that you take that $100 a month and invest it in some mutual fund that earns an 8% rate of return per year. That is a pretty conservative rate of return, but I'll use it anyway for illustrative purposes. Here is what your retirement account will look like at various points in time:

• After 10 years, you will have $18,294.60.
• After 20 years, you will have $58,902.04.
• After 30 years, you will have $149,035.94.
• After 40 years, you will have $349,100.78.

Those are some pretty amazing amounts of money, just from giving up lattes and lunches out!

Note how much of a difference those 10 years make. Starting at age 25 instead of 35 translates into an extra $200,000 when you retire! I don't know about you, but if somebody offered me $200,000 just for giving up lattes and lunches for 10 years, I am taking it with both hands! The amazing thing is that people will sell their souls to the devil (err...reality TV producers) for a lot less money than that. However, judging by the lines at McDonalds and Starbucks, people aren't too interested in that $200,000 payday.

There are two things you should take away from this example. First, even a little bit of money, invested regularly, can turn into a big amount of money with the power of compound interest. Second, the earlier you start investing, the more powerful compound interest becomes!