Compound interest is one of the most repeated concepts of personal finance. The principle is that the interest you earn also will earn interest, and over time that can add up to a lot of extra cash.
But it doesn’t always work as miraculously as described.
The web comic xkcd offers a funny counter-example if you were to compound a measly 2 percent rate over a time of 10 years. Let’s lee the magic of compound interest!
Below I offer a couple more graphs to demonstrate what is really going on.
An example
Let’s say you can invest money at a 10 percent rate (which is somewhat optimistic considering the performance in recent years).
How much extra money does compound interest earn you?
Here is a graph for a 10-year period.
Compound interest makes no significant difference over the first 5 years, and then it starts to matter a bit by the 10th year.
The real difference happens over time. If you invest for 20-years, then we have the following picture:
You’ll notice most graphs for the “miracle” of compounding will have at least 20-year period. This is a bit misleading since few people can save for that kind of time frame, and no one can predict what the market will do 20 years from now. Stable returns are not guaranteed.
In short, the numbers do not support the notion that compound interest is a magic bullet.
THE LESSON
Compound interest makes a difference OVER A LONG TIME. The real factor is time: compound interest makes a significant difference over a period of 15 or 20 years.
If you expect large investment gains in the stock market within 5 or 10 years, perhaps you really will need a miracle.
Myth/reality check: the miracle of compound interest
No comments:
Post a Comment