Okay, so that’s not entirely true. Compound interest can make you rich, but for most of us, the equation just doesn’t make sense.
Before we get started, let’s clear some things up. I am not saying that you shouldn’t invest. Investing is critically important, and compound interest is powerful stuff. But I want you to go into the game with your eyes open.
Secondly, let’s define “rich” as when you can be upper-class without working. In the United States, you’ll need about $5 million minimum. Of course it varies depending on where you live, but $5 million is an easy number to work with that makes sense for most of the country. If you invest all $5 million and get 5% per year, you’ll make about $250,000 in passive income.
For those who are unfamiliar with compound interest, it occurs when the interest that accrues to an amount of money accrues interest on itself. So, interest on top of interest.
In my book, I made some comments about compound interest that caught some criticism. Seemingly every single personal finance writer, blogger, guru, and television personality preaches the power of compound interest. They’re right – compound interest is incredible. Let’s check out the stats:
$10,000 invested at an 8% rate of return will be over $100,000 in thirty years.
Want to set things up for your future great-grandchildren? That same $10,000 turns into almost $22 million in 100 years.
Pretty cool stuff! But let’s take a big picture look at compound interest. For compound interest to be effective, you need three things.
2. Investment Yield
3. Money Invested
Let’s look at these three things in more detail.
You cannot control time. It’s finite. While you can always make more money, you can never get more time, so use yours wisely.
The real secret is to separate your income-generating activities from your time. Like I mentioned in a previous article, having a job can be a wonderful thing, but it absolutely cannot be your only source of income.
I’ll be completely transparent – I’m spending my valuable time writing this blog because I know that I will only have to write this post once, but it will continue to generate revenue for me for many years. I’ll get ad revenue, sponsored posts, affiliate sales, product sales, and so on. This post will bring eyeballs to my site, which will generate revenue for me, even when I sleep. The potential return on this blog post is exponential and near-infinite. If you invest money into the stock market at age 45, you know you’ve only got 20-some years left until retirement.
How long are you willing to wait? I’m reminded of a story about Coca-Cola’s initial public offering (IPO). The company went public in 1919 for $40 per share. If you had invested $40 into a single share of Coca-Cola in 1919 during the IPO, your investment would be worth over $400,000 today. If you reinvested your dividends, you would have over $10 million.
Okay, so best case scenario, someone invested $40 for you (which was really like $600 today) on the day you were born and you never sold it. Even through depressions and wars, you held onto that stock. Oh, and you had the good sense to reinvest your dividends. You would now be 97 years old and worth $10 million. Pull the Ferrari up, Grandpa!
Of course, if you’re willing to wait many years to get “rich”, investing early is the way to go. If you’re under the age of 35, you’ve got one of the biggest advantages when it comes to planning your financial freedom. You can sock money away each and every month and let it work for you. The sooner you start, the greater the advantage you’ll have.
I don’t know about you, but I can’t call up Wall Street and demand to get a 10% return on my money this year. It just won’t happen. You have some control over taxes and fees, which can help you build a sizeable nest egg, but you can’t email your mutual fund company and demand a certain return.
This is the only variable that you can truly control. You cannot get more time, and you cannot force an investment yield from the stock market. The way to subvert this fatal weakness is to invest bigger numbers. When you start thinking this way, your attention will shift. You’ll realize that real wealth is time. You’ll never, ever get more time. So when you use the laws of mathematics to your advantage, you can leverage higher numbers to bend compound interest to your will.
Compound interest works, but it’s much friendlier to big numbers. If you start with a million dollars, compound interest is a beautiful thing, and you can make that last a long time. However, the average earner in America has tremendous difficulty stuffing money away.
Finally, assuming that you’re a typical earner and you’re somehow able to sock away a huge amount of your income, how much are you sacrificing to do it? The average household income in America is about $50,000 and has just over two wage earners, meaning that average earnings per person is about $25,000. Trying to save $1,000 per month so you can have over a million at age 65 is a bit of a stretch. After taxes, you’re left with even less, and you still have to eat and get shelter. It’s not a good outlook.
“Well, get an education and get a better job!” you say. According to the National Center for Education Statistics, the median annual earnings for a college graduate aged 25-34 is about $47,000. At that income level, saving $1,000 per month is 25% of his/her income. The Richest Man In Babylon talks about saving 10%, and people still struggle with that!
What Happens In Retirement?
Let’s assume that you’re somehow able to stuff away $1,000 per month every single month from the time you’re 25 years old to 65. You never miss a month. This implies you never had a major medical emergency and never lost a job or income source. Congratulations! You now have over a million dollars! It’s time to pop champagne like you won a championship game. Not quite…
As the years pass on, your purchasing power decreases. We’ll assume that on your 65th birthday you look at your account statement and see a cool $1.3 million. If you live until you’re 90 years old and never earn another dime (but also don’t lose any of your initial principal), you’ll have $52,000 per year. This isn’t bad at all, but certainly not rich. One million dollars isn’t really “rich” anymore. It now includes ordinary, non-rich people who just had the good sense to save for retirement. Those with just one million at retirement can’t sustain an upper-class lifestyle, and they know it.
If you want to get from point A to point B quicker, you go faster. This makes sense logically, but people still trudge along, either not investing anything at all or only investing a small amount. When you save and invest more money, you speed up. You can increase your income, not change your lifestyle that much, and reach your goals that much faster.
Compound interest is awesome, but it cannot accelerate wealth quickly. Getting a job and stuffing a few hundred into a portfolio each month won’t do much for you. You’ll still be better off than the average person, but it’ll take decades to propel your wealth into the stratosphere.