In this post, I want to discuss one of the best-kept and most powerful secrets in the world of investing: compound interest. Unlike simple interest, which only generates returns on the original capital, compound interest generates returns on previously accumulated earnings, thereby accelerating capital growth over time.
The earlier you start investing, the more effective this phenomenon becomes, as it maximizes the time your capital generates returns. But let’s start with the basics: What is compound interest?
What is Compound Interest?
Compound interest is the accumulation of earnings on top of earnings. In other words, you not only earn returns on your initial investment but also on the gains generated over time. This creates a “snowball effect,” where your capital grows more rapidly the longer it remains invested. Let’s see a simple example to illustrate this.
Example: Investing in Your 20s vs. Your 40s
Let’s suppose two investors plan to retire at 65. The first investor starts investing at age 25, while the second starts at 40. Both invest $10,000 annually, with an average return of 7%, based on the historical performance of the S&P 500.
- Investor starting at 25: By investing for 40 years, until the age of 65, this person would accumulate approximately $2,147,000. This amount includes both annual contributions and the returns generated through compound interest.
- Investor starting at 40: This person invests for only 25 years, and by age 65, their capital would grow to around $655,000. While they invest a significant amount, the lost time dramatically reduces the impact of compound interest.
S&P 500 Performance and Final Thoughts
Historically, the S&P 500 has provided an average annual return of 7% to 10% over the past 100 years. This means that, on average, an investment in this index could double roughly every 10 years. The effect of compound interest on a long-term investment in the S&P 500 is significantly powerful, especially for those who start investing at a young age.
Compound interest rewards those who start investing early. The longer you allow compound interest to work, the greater your accumulated capital will be. Those who begin investing in their 20s or 30s have a considerable advantage over those who start in their 40s, as the exponential growth of capital strengthens over time. Investing in diversified vehicles like the S&P 500 can yield solid long-term returns, making compound interest an essential ally in retirement planning.