Compound interest is the eighth wonder of the world. He who understands it earns it he who doesnt pays it, Albert Einstein once said. For those who arent financial gurus, allow me to put this quote in laymans terms: everyone whos able to save up a little, and is patient enough, can get wealthy. Its not how celebrities get rich, its how the millionaire next door gets born.
So how does it work?
To become this achievable millionaire next door, you dont have to win the lottery, or have an IQ as high as Einsteins. All you have to understand is one investment concept called compound interest, and of course make it work for you.
It works as follows. Say you invest $1000 in the broader market, using a relatively low-risk index fund (a basket of a broad range of stocks) such as the S&P 500 or an even more diversified total world stock market index fund, and you gain 8% in a year on capital gains and dividends (sort of the average annual return). After a year, your capital has grown from $1000 to $1080. Your profit is $80 after the first year.
Now lets say you choose to keep the $1080 invested (including reinvesting the dividends). After the second year the $1080 grows another 8% (again, this is hypothetical, as the annual return fluctuates) to $1166.40, meaning your annual profit has gone up from $80 to $86.40.
Your money is growing faster because youre not just growing your principal of $1000, but also last years earned interest of $80. Youre making interest on interest, in other words compound interest. On average your yearly earnings will grow, just by keeping it invested, and thus making it work for you.
How can we simulate this?
The main ingredients for generating compound interest are:
- Investing money, preferably adding a steady amount each month. This is called dollar-cost averaging, and prevents you from going all in at the wrong time (i.e. the markets low).
- Time, lots of time, for your money to grow by reaping the benefits of compound interest generated by the market. Youre aiming for the so-called hockey stick effect to kick in, which means the longer you let your money work, the faster it rises.
Hockey stick effect for doubling your money each year, on a $10,000 principal
Thats all there is to it. So youre probably wondering what would happen if you actually put aside say $500 a month for say 30 years, while the markets 8% average return would continue to occur. Well, weve created a template for you just for that.
All you have to do is head over to the Google Sheet document, make a copy of it for yourself by heading to the menu and hitting File -> Make a copy. Then, change the main parameters on the right under Capital already invested if you already have money invested in the market, Extra savings invested per month, and optionally tweak the Average monthly return to increase the annual return (in red) if you expect a lower or higher annual return than 8%.
So there you have it. Money doesnt necessarily just have to be for the few, as long as you have patience and perseverance.
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