Commandment 1: Heed Compounding Interest
This is the first of a ten part series where we look at Haven’s Ten Commandments, a short list of investing fundamentals we like to teach to our clients. It’s nothing too fancy, but a good foundation we believe everyone should understand.
Compound Interest is the result of combining two things: compounding (to build upon oneself) and interest (the money part of the equation).
When a plant starts to grow, the beginning is slow and focused (one stem), but overtime that plant produces many sprouts or branches, with each one the amount the plant grows is increased. When I start running again after a cold winter my runs are hard and short, but with dedication and routine I begin to build on each of my previous runs. Eventually I am able to run faster, my breathing becomes steadier, I can run farther. When you're dealing with money, it's no different. Compounding happens everywhere in life: in nature, in fitness, in health, in education, in money. In most cases it's hard to notice, but the benefits can be amazing.
Albert Einstein referred to compound interest as ‘the most powerful force in the universe’, a pretty big statement considering the magnitude of his studies and pursuits.
Compound interest is the 'secret stuff' that really makes investing work for you. I think we all have heard about compound interest in one way or another, and it sounds good but only if we know two things: How it works, and how we can take advantage of it.
Compound interest is really a straightforward concept. In exchange for investing money, you get to earn the benefit of receiving interest on your investments. It’s effectively flipping the traditional roles of debt. Instead of you paying interest you’re now in the position to earn it. Compound interest works by earning interest on the initial principal (money you invested) and over time, you ALSO earn interest on the interest your money makes.
Let’s look at an example to help paint a clearer picture. Let’s say you invest $100 and earn 10% a year.
As you can see in the table, we aren’t adding any additional money, but each year our Interest Earned increases because it incorporates the value added from the interest. This example is very small scale, so let’s check out an example of a one time contribution of $10,000.
Over 40 years the advantages of compound interest are hard to believe. The longer your money is invested, the longer it has time to work for you, and the larger the increases in value. Just like any goals or skills that are developed over long periods of time, you can find yourself looking back at and in amazement of what you can do or know. Think about something you do regularly right now, maybe it's your current job, maybe you're in school, networking and building relationships, training for a long run or body building competition, or even investing or paying off debt. Now think about your first day at the starting line. I bet there were things you thought you could never do that you're able to do now with ease.
With a good plan and dedication, impossible things become everyday things, and your daily goals become your daily warm-ups. This is how you can take advantage of compound interest, get your money working for you by investing it for the long term. Start early and stay committed.
If you have any questions about compound interest, general investing or learning about how Haven can help you, don't hesitate to reach out.
- Derek Condon