Lesson three: compound interest

The most interesting illustration of compound interest I have encountered was a question I encountered years ago. The question is: would you rather have a penny that doubles each day for a month or one million dollars? 

To be honest, like most people, I got caught up in the initial number. One million dollars, of course! I thought. However, if you took a penny and doubled it every day, after 30 days you would end up with an amount of $5,368,709.12.

That is the power of compound interest. When you start investing, the returns on your money appear small. But there is power in starting early and investing consistently. As your money starts to build, the gains start to get bigger. 

When people hear about investing, a common response is “But I only have [insert small amount of money], so it doesn’t even seem worth it”. 

The beauty of compound interest is that it works with any amount. Obviously, yes, your gains are more noticeable when you have a bigger amount of money, but the point still stands. Compound interest works whether you start with $10 or $10,000. 

Compound interest is the interest on your money calculated on both the initial principal and the accumulated interest from previous periods. You’re earning interest on your interest! 

Example

The above image shows how much your money can grow with compound interest depending on how much you invest. The beauty of compound interest is that it works for every dollar amount. Even if you can only invest a small amount every month, you’ll still reap the benefits of compound interest. 

As you can see from the image, it’s important to invest early and often. The earlier you start, the more time you have to let your money compound. That’s why financial professionals always talk about the importance of starting to invest when you are in your 20’s. 

It’s not too late if you’re 35, 40, 45, and so on. You will just have to invest more money. 

You cannot save your way to wealth

Investing in the stock market can be a daunting task. You may think “I’ll just put my money in a high yield savings account where it’s safe from market ups and downs”. On first glance, that seems like a good idea. 

At the current moment, there are high yield accounts such as the Wealthfront Cash account, which has a 5.00% APY on all of your cash. 

However, savings accounts didn’t always pay those rates. For a period of around 2008-2022, savings accounts, even the “high yield” ones, only had around 0.50-2.00% APY. This is because savings accounts follow the federal funds rate (FED). For over a decade, the FED rate was really low, making savings accounts interest rate really low. 

That changed in 2022 when, in an effort to curb the high inflation rate, the FED started aggressively raising the federal funds rate. As the FED rate went up, so did the savings account interest rates and the borrowing rates for loans. 

If you pull back and see the average savings account interest rate over the past 20 years, it’s about 1-2% APY. The S&P 500 has had a 10% average rate of return from March 2004-March 2024. 

Investing in the stock market is the way to beat inflation and build wealth. 

That’s not to say you shouldn’t use a high yield savings account. You should! A high yield savings account is a great place to store money you will need in the near future. Think 1-5 years. It’s a good place for storing your emergency fund, vacation fund, car fund, home down payment, or any other money goal you have in the near future. 

For long-term goals (7+ years), such as retirement, investing in the stock market can be a good way to go. 

Use this handy S&P 500 calculator to see the average long-term returns of the S&P 500 over different periods of time.